TAX PLANNING AND TAX STRATEGY CONCEPTS
Taxes are the way through which we contribute to public expenditures for the development of the nation and even though it may not exactly be an easy process to undertake, it must nevertheless be done. To this effect, planning your tax strategy is of utmost importance in order to create a tax-efficient plan that minimizes how much you pay in taxes.
- What is tax planning?
- Planning your Tax Strategy for Retirement Plans
- Tax Gain-Loss Harvesting
- Payment plans
- The tax strategy concepts you should know
What is tax planning?
Tax planning refers to the analysis of a person’s financial plan or situation to ensure that tax liabilities are minimized and tax breaks are maximized in an efficient and legal way, to allow you to pay the lowest taxes possible.
Without a basic understanding, the rules that guide the payment of taxes could sometimes be complex and problematic. However, developing an understanding of taxes and your own tax plan can benefit you immensely by decreasing the amount that you pay when you file.
Planning your tax strategy covers considerations like timing of income, size, timing of purchases, and planning for other expenditures to produce the best possible result.
Planning your Tax Strategy for Retirement Plans
Using a retirement plan like the individual retirement account (IRA) to save is a common way to reduce taxes. By contributing money to a traditional individual retirement account, you can minimize your gross income by the amount contributed. This means that if you meet all requirements (for 2020 and 2021) and you are 50 years or older, then you can contribute a maximum of $7000 to your IRA.
A 55-year-old person earning $60000 annually and making a contribution of $7000 to a traditional IRA would have an adjusted gross income of $53000 while the contribution of $7000 would grow tax-deferred until the time of retirement. If you are less than 50 years old, then you are permitted to contribute a maximum of $6000 to your IRA.
Apart from the traditional IRA, other retirement plans exist that you could use to reduce tax liability. One of such retirement plans is the 401k that is more common with large companies that have a lot of employees. Those that use the 401k plan can contribute income from their salary directly into their company’s 401k plan. Here, one of the key differences is that the contribution limit is higher than that of an individual retirement account.
A 55-year-old man earning $60000 annually could contribute up to $26,000 into his 401k and this means that his adjusted gross income reduces to $34000. Those under the age of 50 years (for 2020 and 2021) can contribute up to $19,500 while those above 50 years can contribute up to $26000.
Tax Gain-Loss Harvesting
What tax gain-loss harvesting does is to use a portfolio’s losses to offset overall capital gains. The Internal Revenue Service (IRS) states that short and long-term capital losses must be used to offset capital gains that are of the same type first. This means that long-term losses offset long-term gains before offsetting short-term gains. Earnings from assets owned for less than a year or short-term capital gains are taxed at ordinary income rates.
Long-term capital gains are taxed as follows (from 2020):
- For taxpayers with income less than $78,750, they pay 0% tax.
- For single taxpayers with income that is more than $78,750 but less than $434,550, they pay 15% tax ($488,850 if married filing jointly or a qualifying widow(er), $461,700 for the head of the household, or $244,425 for married filing separately).
- For taxpayers with income higher than listed for the 15% tax, they pay 20% tax.
The IRS states that if your capital losses exceed your capital gains, then the amount of the excess loss that you are allowed to claim to lower your income is the lesser of your total net loss or $3,000 ($1,500 if married filing separately).
If you are unable to make payment when due, you could request a payment plan. It is an agreement with the IRS to pay the taxes you owe within an extended timeframe and should be requested if you believe you can pay within the extended period. Federal tax payment plans, income tax payment plans, and property tax payment plans can be taken advantage of for payments at later dates.
The tax strategy concepts you should know
The following are some tax planning concepts that you should understand when planning your tax strategy.
i. Knowing your tax bracket
The United States’ progressive tax system ensures that those with higher taxable incomes pay higher tax rates while those with lower taxable incomes pay lower tax rates. The federal tax payment plan is divided into seven income tax brackets: 10%, 12%, 22%, 24%, 32%, 35% and 37%. However, you probably won’t pay the rate of the bracket you fall into on your whole income because of tax deductions which will determine your taxable income and because your taxable income is not just multiplied by your tax bracket. Your taxable income is divided into chunks which are then taxed at corresponding rates.
ii. The difference between tax deductions and tax credits
They both reduce your tax bill in different ways. Tax reductions reduce the amount of your income that is taxed while tax credits give you a dollar-for-dollar reduction in your tax bill. So, if a tax credit is valued at $2500, it lowers your tax bill by $2500.
iii. Taking the standard deduction vs. itemizing
The standard deduction is a flat-dollar tax deduction and it makes tax preparation very fast. Itemizing on the other hand means taking all the individual tax deductions that you qualify for, one by one. If itemizing adds up to more than the standard deduction, then you’d probably prefer to do that.
iv. Be aware of popular tax deductions and credits
There are a lot of possible credits and tax deductions. Knowing if you are eligible helps you take advantage of them. Some popular ones are saver’s credit, property taxes, medical expenses, mortgage interest, child tax credit, adoption credit, and others.
v. Know what tax records to keep
Some of the tax records you should keep for if you are ever audited are: income, home, expenses and deductions, retirement accounts, and investment records.
vi. Tax strategies to shelter income or cut your tax bill
Apart from credits and deductions, you could take advantage of the following to reduce your tax bill even more: put money in your IRA or 401k, fund your flexible spending account (FSA), tweak your W-4, open a 529 account and maximize Health Savings Accounts (HSAs).
Tax planning is essential if you want to pay the lowest taxes possible. Arrowroot Family Office is a wealth management service that provides tax services that combine the skills and experiences of professionals to help you with tax planning strategies, ensuring you pay the lowest taxes possible in a legal and efficient way. Don’t hesitate to contact us today to get started.