What is Tax Planning?
Everybody deals with finances—it’s often just done in different ways. One way to work with your finances is through tax planning. Tax planning is a process that helps you reduce the amount of taxes you’ll owe at the end of each year. There are a number of ways you can go about tax planning, but it primarily involves three basic methods: reducing your overall income, increasing your number of tax deductions throughout the year, and taking advantage of certain tax credits.
Why is Tax Planning Important?
The reason why tax planning is important is simple: it saves money and helps you avoid overpaying your taxes. Aside from that, however, tax planning will help you better understand what you’re spending money on and how you can get rewarded for planning for retirement or advancing your education.
Strategic Tax Planning is something you most likely aren’t receiving from your CPA. There are a few reasons why this is true.
- Accountants only understand a small portion of the tax code. Instead of being future focused, they are more interested in historical record keeping. While some may provide reactive tax advice, they are unaware of how to proactively and strategically make the tax code work in your favor.
- Accountants are likely to have Type-A personalities. While that’s great for plugging numbers into boxes, it means they probably aren’t flexible or open to change. A strategic tax planner must take into account the small business owner’s lifestyle, short and long-term financial goals, and spending habits.
- Accountants err on the side of caution. Though there are over 70,000 pages of green lights in the tax code, accountants tend to focus on the five pages of red lights to avoid being flagged by the IRS. It’s important to understand, however, that a green light is not the same as a “loophole.” It’s not a “red flag” to go through the intersection and it does not increase your risk of getting a ticket because you “used” this particular law to get through the intersection. Remember, the tax code was meant to be used, not feared.
A lower tax bill is within reach
So you want to pay less tax in 2019. Who doesn’t? The good news is, there are ways to reduce the amount of money that you send to the IRS — legally, without allegations of tax evasion. In fact, there are plenty of steps you can take to cut your federal and state tax bills. And, the sooner you start, the more things you can do to reduce the taxes you’ll owe.
Contribute as much as you can to retirement accounts
Want to set yourself up for the future while slashing your tax bill at the same time? Contribute to tax-advantaged retirement accounts such as a 401(k) and IRA. Unless you opt for a Roth account, you can take deductions for your contributions in the year you make them. This enables you to deduct a lot of money. You can contribute up to $19,000 to a 401(k) and up to $6,000 to an IRA in 2019. You can also make additional catch-up contributions of $6,000 to a 401(k) and $1,000 to an IRA if you’re over 50.
Take advantage of tax loss harvesting
If you have losing investments, selling them allows you to harvest your losses to offset taxes on investment gains or to reduce your taxable income by up to $3,000.
This strategy can be especially beneficial if your income is going to be higher than normal and you want to avoid being pushed into a higher tax bracket, or if you’re going to be selling investments that you’ll need to pay short-term capital gains on.
Keep track of your medical costs
If you incur substantial medical expenses, you may be able to take a deduction for the funds you spent. In 2019, you can deduct unreimbursed allowable medical expenses only if they exceed 10% of your income — up from 7.5% in 2017 and 2018. You’ll need to itemize to claim this deduction — which doesn’t make sense for many tax payers due to the large standard deduction. Still, you should keep the bills you incur throughout the year. If your costs are high enough to hit the threshold for deductibility, you want to be able to take advantage of the tax savings to offset some of your big care expenses.
Put some cash into flexible spending plans
If your employer offers flexible spending accounts, you should likely take advantage of them.
You can make contributions to an FSA with pre-tax funds to pay qualifying out-of-pocket medical expenses. You could potentially also enroll in a dependent care FSA to pay for services such as child care or care for a disabled relative. It’s important to know the rules for FSA contributions. You’ll usually have to enroll in an FSA during open enrollment with your employer, and many plans are structured so if you don’t spend your contributions, you lose them. Still, if you know you’re going to have out-of-pocket medical costs or dependent care costs to pay, you should strongly consider putting some money into the FSA to reduce your taxable income and make these expenditures effectively cost less.
Smart Qualified Plans
On a more pedestrian note, business owners can often use tax deductible retirement plans much more to their advantage than is typically the case, if the objective (as it nearly always is) is to pile up tax deductions while putting way more dollars in owners’ accounts than for employees. I say pedestrian because this is really business tax planning 101, straight down the fairway, but I am continuously amazed at how often it is missed by even high-dollar tax advisors. I recall a case where a Manhattan CPA advised a fellow to use a SEP, with deductions in the $20K range. Mind you this client lives near NY and pays NY State and municipal income taxes on top of the Federal burden, meaning he really got whacked. We showed him how, in his fact pattern, using a 401(k) would more than double his CPA-suggested deduction, but that what he really needed (and eventually did) was a defined benefit plan, boosting deductions to about $150K a year. The guy saved pushing $100K a year in taxes, like waving a wand.
Invest in Registered AccountsTax-Free Savings Account (TFSA)
In addition to investing in a TFSA of your own, consider making a gift to your adult family members or spouse to enable them to contribute to a TFSA. All the investment income in the TFSA grows tax-free and future withdrawals are not taxable. Further, there will generally be no income attribution, regardless of who funds the account. If gifting to your spouse, attribution will not apply so long as the funds remain invested in the TFSA.
Registered Retirement Savings Plan (RRSP)By investing in an RRSP
you can deduct the amount of your RRSP contribution from your taxable income, up to your annual RRSP deduction limit, thereby reducing the taxes you will have to pay. In addition, funds in an RRSP grow on a tax-deferred basis. The investment income and capital gains generated in the plan are not subject to tax until you make a withdrawal in the future.You may also want to consider contributing to a spousal RRSP for your low income spouse to equalize future retirement income. In doing this, the high income spouse utilizes their RRSP contribution room when making a contribution and is able to claim the deduction on their return. The RRSP/RRIF withdrawals will be