Tax planning is the analysis of your life and business to optimize your situation so you can pay less in taxes. As you begin to tax plan, you need to first have a grasp on two basic terms.
Tax deductions: What you can subtract from your taxable income. As you look over specific expenses you incur throughout the year, they may be deductible and can reduce the amount of income subject to taxes.
Tax credits: What can directly lower your taxes. A tax credit of $2,000 lowers your tax bill by $2,000.
Tax planning involves arranging your finances in order to maximize tax credits and tax deductions while legally reducing tax liabilities. This also involves consideration of the timing of receiving income and making purchases. Of course, these are just the basics. If you want more information about what is tax planning, then keep reading.
What are tax planning strategies?
Tax planning strategies are specific strategies people use in order to legally reduce their taxes. There are many tax planning strategies, especially when considering tax planning in 2021. Owning a business traditionally allows more tax planning opportunities than an individual earning W-2 income, although there are tax planning strategies for both scenarios.
Examples of individual tax planning strategies to lower taxable income include tactics such as retirement contributions and charitable donations. Business tax planning strategies are numerous. There are hundreds of strategies out there for further exploration, which we’ll get to soo There are hundreds of strategies out there for further exploration, which we’ll get to soon.
How to Understand Tax Planning
Most people don’t tax plan because they either don’t understand it or it seems like too much work to implement. This is because building a tax plan is only half the battle. If you want to realize the savings from your tax plan, you must take the necessary actions to make that happen.
For example, a C Corp might find it beneficial to change to an S Corp. In this case, in order to realize the tax savings, the business would have to actually change it’s legal entity. This is an example of implementing a tax planning strategy.
What is Basic Tax Planning?
There are many popular tax planning strategies that are used in 2021, but one of the most basic strategies that can provide a huge impact is retirement planning. A good tax plan should confirm that your retirement plan is the most appropriate one for your situation, whether it’s a 401(k), IRA, SEP, etc.
Retirement plans are an efficient way to reduce and defer taxes, and all it takes is contributing money once you’ve set it up. A taxpayer under 50 can contribute a maximum of $6,000 to their IRA and $7,000 if age 50 or older. To take a practical example, a 54-year-old with an income of $50,000 who made a $7,000 contribution to a traditional IRA has an adjusted gross income of $43,000. What this means is that $7,000 grows tax-deferred until retirement.
Tax Planning for Investors
One of the easiest ways investors can save on taxes is by tax gain-loss harvesting. Capital gains rates could be increasing soon, which means tax gain-loss harvesting is going to be a popular way of tax planning in 2021. This strategy uses a portfolio’s losses to offset overall capital gains.
For example, if you have $20,000 in long-term capital gains with a tax liability of $3,000, you could sell underperforming investments carrying $20,000 in long-term capital losses to offset the gains. If an investor has $3,000 in net capital losses for the year, their $50,000 income will be adjusted to $47,000. This tax planning strategy can help you lower your tax liability.
Should I Be Doing Tax Planning in 2021?
Many tax policies are subject to dramatic changes with the recent elections shifting the balance of power. Many Amercians will find they owe more in taxes this upcoming year, especially business owners who could see a rising C Corp and individual tax rates. What this means is that tax planning will be in demand for years to come.
Everyone should have a tax plan, just as everyone should be making sound financial decisions. Of course, we know in reality many people don’t do this—they don’t make the best financial decisions and they don’t do tax planning. However, if everyone were to see the amount of money they are overpaying the IRS, most would make an effort to tax plan. Think about it like this: would you put $20,000 in a paper shredder? Of course not, but not having a tax plan could be the equivalent, because you’re throwing money away by needlessly overpaying the IRS.
No matter if you use a professional tax planner or tax plan yourself, it’s likely you can save yourself some money simply by doing any kind of tax planning. The vast majority of Americans don’t tax plan, and consequently end up overpaying the IRS—even though they don’t know it. With many tax policy changes likely coming in 2021, this is the perfect year to make your first tax plan!
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