Tax Planning
What Is Tax Planning?
According to Investopedia, tax planning is the analysis of a financial situation or plan to ensure that all elements work together to allow you to pay the lowest taxes possible. A plan that minimizes how much you pay in taxes is referred to as tax efficient. Tax planning should be an essential part of an individual investor's financial plan. Reduction of tax liability and maximizing the ability to contribute to retirement plans are crucial for success.
KEY TAKEAWAYS
Tax planning is the analysis of a financial situation or plan to ensure that all elements work together to allow you to pay the lowest taxes possible.
Considerations of tax planning include the timing of income, size, the timing of purchases, and planning for expenditures.
Tax planning strategies can include saving for retirement in an IRA or engaging in tax gain-loss harvesting.
Understanding Tax Planning
Tax planning covers several considerations. Considerations include timing of income, size, and timing of purchases, and planning for other expenditures. Also, the selection of investments and types of retirement plans must complement the tax filing status and deductions to create the best possible outcome.
Tax Planning for Retirement Plans
Saving via a retirement plan is a popular way to efficiently reduce taxes. Contributing money to a traditional IRA can minimize gross income by the amount contributed. For 2020 and 2021, if meeting all qualifications, a filer under age 50 can contribute a maximum of $6,000 to their IRA and $7,000 if age 50 or older. For example, if a 52-year-old male with an annual income of $50,000 who made a $7,000 contribution to a traditional IRA has an adjusted gross income of $43,000, the $7,00 contribution would grow tax-deferred until retirement.
There are several other retirement plans that an individual may use to help reduce tax liability. 401(k) plans are popular with larger companies that have many employees. Participants in the plan can defer income from their paycheck directly into the company’s 401(k) plan. The greatest difference is that the contribution limit dollar amount is much higher than that of an IRA.
Using the same example as above, the 52-year-old could contribute up to $26,000 into their 401(k). For 2020 and 2021, if under age 50, the salary contribution can be up to $19,500, or up to $26,000 if age 50 or older due to the allowed additional $6,000 catch-up contribution. This 401(k) deposit reduces adjusted gross income from $50,000 to $24,000.
Tax Gain Loss Harvesting
Tax gain-loss harvesting is another form of tax planning or management relating to investments. It is helpful because it can use a portfolio's losses to offset overall capital gains. According to the IRS, short and long-term capital losses must first be used to offset capital gains of the same type. In other words, long-term losses offset long-term gains before offsetting short-term gains. Short-term capital gains, or earnings from assets owned for less than one year, are taxed at ordinary income rates.
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