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What is Tax Planning?

What is Tax Planning?

Tax planning generally involves income tax minimization strategies. For example, defer income, maximize deductions, and select tax-subsidized investments. Unlike regular tax reduction planning, total wealth planning has increased, in some cases, the taxable income of many taxpayers. If an increase in income tax or income tax rates is expected in the future, increasing certain types of taxable income in the current year can save significant taxes in the future coming years. This could be done by generating long-term investment income or possibly by converting a traditional IRA into a Roth IRA.

You need to look beyond tax preparation to maximize deductions. Proactive tax planning throughout the year is the key to reducing taxes and maximizing after-tax wealth for wealth creation. This is done by applying changes in tax law to your specific situation.


Understanding Tax Planning

Tax planning includes several considerations. Considerations include the size and timing of purchases, the timing of income, and planning for other expenses. In addition, the selection of investments and types of pension plans should incorporate tax status and deductions to create the best possible result.


Tax Planning for Retirement Plans

Saving through 401(k) is a popular way to reduce taxes effectively. Contributing money to an IRA can minimize the gross income with the amount contributed. For 2020 and 2021, if you meet all the conditions, someone under the age of 50 can contribute up to $6,000 to the IRA and $7,000 if you are 50 or older. For example, if a 55-year-old man with an annual income of $50,000 who made a contribution of $8,000 to a traditional IRA has an adjusted gross income of $42,000, the contribution of $8,000 would grow tax-deferred until retirement.

There are many other retirement plans that a person can use to reduce their tax liability. 401(k) plans are popular among large companies that have many employees. Plan participants can defer their salary income directly to the company's 401(k) plan. The biggest difference is that the dollar value of the contribution limit is much higher than that of an IRA.

Using the same example above, the 55-year-old could contribute up to $26,000 to 401(k). For the 2020 and 2021 fiscal years, if you are under 50, your salary contribution can go up to $19,500 or up to $26,000 if you are 50 or over, thanks to the eligible additional recovery contribution of $6,000. This 401(k) deposit reduces the adjusted gross income from $50,000 to $24,000.


Tax Gain-Loss Harvesting 

Another form of tax planning or tax management is the perception of tax gains and losses. This is useful because you can use portfolio losses to offset total capital gains. According to the IRS, short-term and long-term capital losses must first be used to offset capital gains of the same nature. In other words, long-term losses outweigh long-term gains before making up for short-term gains. Short-term capital gains, i.e., capital gains on assets held for less than one year, are taxed at normal rates of return.

From 2020, long-term capital gains are taxed by the IRS as follows:

  • 0% tax for taxpayers with income is less than $78,750

  • A 15% tax for single taxpayers whose income is higher than $78,750 but less than $434,550 ($488,850 if married and declaring joint tax or eligible widow's tax, $461,700 per household, or $244,425 for a separate tax return for the spouse)

  • 20% tax for taxpayers whose income is higher than that indicated for the 15% tax

For example, if a single investor with an income of $80,000 had $10,000 in long-term capital gains, the investor would have a tax liability of $1,500. If the same investor sold underperforming investments with $10,000 in long-term losses, the losses would exceed the gains, resulting in a tax debt of $0. If the same lost investment was recovered, a minimum would be spent days to avoid liquidation.

According to the Internal Revenue Service, "If your capital loss exceeds your capital gains, the amount of excess loss you can claim to reduce your income is less than $3,000 ($1,500 if you are married, filing separately) or the total net loss posted on line 21 of Schedule D (Form 1040 or 1040-SR).

For example, if the 55-year-old investor had had $3,000 in net capital losses during the year, the income of $50,000 would have been adjusted to $47,000. Residual capital losses can be carried forward without expiration to offset future capital gains.


Asset Location Strategy

Understanding which account should contain more asset classes is important for effective tax planning. Depending on the type of investment, the asset class can generate income as defined by the IRS. It can be considered ordinary income, eligible capital and dividends, and tax-free income. A tax professional who knows what you want will strive to place these asset classes in accounts with the most favorable tax implications.


Ordinary Income

Investments generally generate income that may be subject to different types of tax rates. Interest income on savings accounts, certificates of deposit, money market accounts, annuities, bonds, and certain preferred stocks and certain dividends are subject to normal tax rates. These are based on the taxpayer's marginal share, which is usually much higher than long-term capital gains rates.


Capital gains and eligible dividends

Taxpayers in the 15% and 10% marginal brackets will continue to pay 0% for long-term capital gains and eligible dividends. Taxpayers in the marginal 25% to 35% will be subject to a 15% tax on long-term capital gains and eligible dividends. Taxpayers in the top marginal category of 39.6% will be subject to a tax of 20% on long-term capital gains and eligible dividends. Keep in mind that taxpayers subject to the 20% tax rate will have their net investment income subject to the new Medicare supplement of 3.8%.


Income without Tax

This income is exempt from federal and/or state taxes, depending on the type of investment vehicle and the issuing state. Municipal bonds and US bonds are typical examples of investments that can generate income tax-free.


Tax-Deferred Income

Certain income that is deferred at some point in the future is called tax-deferred income. For example, in a 401(k) retirement plan, 403b plan, or traditional IRA, profits are reinvested and taxed only when withdrawals are made from the plan. Income from these types of plans is tax-deferred.

These are some of the effective ways you can plan your taxes.


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