The process of methodical analyzing a financial situation to allow you legally pay the lowest tax possible is known as tax planning. The goal is the overall reduction of tax liability both in the current year and future tax periods. Of course, this can lead to individuals contributing more to their retirement savings.
Tax Planning Considerations
There are many considerations covered by tax planning. Some of these include income timing, timing purchases, and more. Certain factors impart tax planning, a few of which include:
Investing in a retirement plan is widely popular for a good reason. It is one of the ways to efficiently reduce your taxable income. Various retirement plans are available to choose from, with the Traditional IRA being one of the more common options.
When you save money in a Traditional IRA, the amount contributed would accumulate tax-free until retirement. Also, your gross income is adjusted to exclude the contributed amount.
Here’s a simple example to drive home the point. A person with an annual income of $65,000 contributes $6,000 to a Traditional IRA. Their adjusted gross income is now $59,000 (which is subject to taxation), while the $6,000 keeps growing free from taxation.
Other retirement plans are equally available to help you minimize your tax liability. The popular 401(K) is a typical example. Others include the Simple IRA and precious metals IRA.
Tax Gain-Loss Harvesting
This aspect of tax planning deals with the management of investments. One of its major benefits is the ability to make up for capital gains using a portfolio’s losses.
The IRS provision allows for using long and short-term capital losses to counterbalance the same type of capital gains. That’s another way of saying you can only use long-term losses to offset short-term gains after you must have made up for long-term capital gains.
Tax credits refer to the amount you can deduct directly from owed taxes. It doesn’t reduce your taxable income. Instead, tax credits reduce your tax liability on a dollar-for-dollar basis or the total amount of tax you are required to pay.
Tax credits are grouped into three major categories: refundable, partially refundable, and non-refundable tax credits. Generally, you can claim tax credits in several forms, including earned income, child and dependent care, child care, higher education, and more.
Unlike tax credits that reduce the amount of tax you owe, tax deductions lower your taxable income. In other words, they are expenses that you incur and which can be subtracted from your gross income before taxation.
If you make charitable contributions or contribute money to a health savings account, you can claim deductions for these expenses. Other important deductions are property tax, home office, and, of course, the interest on a home mortgage.
Small businesses can take advantage of some lesser-known deductions and significantly reduce their tax liability. For example, carryover deductions (including capital loss and net operating loss), depreciation, and losses on bad debt can all accumulate to a considerable amount.
Tax planning might appear pretty straightforward on paper for some people, but that’s not usually the case in reality for many people. The terms and jargon alone can be very confusing. Thankfully, we are here to help. Let us work with you and, together, map out an efficient tax planning strategy.
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