The Need for Tax Planning
What Is Tax Planning?
Tax planning is the practice of using effective strategies to delay or avoid taxes. When you sit down and make a tax plan with your tax planning advisor, you look at ways to defer or avoid taxes by taking advantage of provisions in the tax law that benefit taxpayers. You find ways to accumulate and speed up tax credits and tax deductions. Tax planning means taking advantage of every tax break available to you under the federal tax code.
Tax planning goes hand-in-hand with financial planning, which means making a plan to achieve your short- and long-term financial goals. It is hard to effectively financially plan for your current situation or your future without employing tax planning strategies to meet those goals.
If you enjoy financial success, taxes will be a large expense. Cutting down on those taxes or even eliminating them when possible is an important element of preserving your wealth.
The main purpose of tax planning is to make sure you approach taxes efficiently. Tax planning reduces your tax liability by employing effective strategies that explore ways that not only decrease taxes but secure a more solid future and retirement. It does not matter whether you make $50,000 a year or $500,000 a year. When you take the time to make a tax plan, you will find numerous ways to save money.
General areas of tax planning
There are several general areas of tax planning that apply to all sorts of small businesses. These areas include the choice of accounting and inventory-valuation methods, the timing of equipment purchases, the spreading of business income among family members, and the selection of tax-favored benefit plans and investments. There are also some areas of tax planning that are specific to certain business forms—i.e., sole proprietorships, partnerships, C corporations, and S corporations. Some of the general tax planning strategies are described below:
Accounting Methods
Accounting methods refer to the basic rules and guidelines under which businesses keep their financial records and prepare their financial reports. There are two main accounting methods used for record-keeping: the cash basis and the accrual basis. Small business owners must decide which method to use depending on the legal form of the business, its sales volume, whether it extends credit to customers, and the tax requirements set forth by the Internal Revenue Service (IRS). The choice of accounting method is an issue in tax planning, as it can affect the amount of taxes owed by a small business in a given year.
Accounting records prepared using the cash basis recognize income and expenses according to real-time cash flow. Income is recorded upon receipt of funds, rather than based upon when it is actually earned, and expenses are recorded as they are paid, rather than as they are actually incurred. Under this accounting method, therefore, it is possible to defer taxable income by delaying billing so that payment is not received in the current year. Likewise, it is possible to accelerate expenses by paying them as soon as the bills are received, in advance of the due date. The cash method is simpler than the accrual method, it provides a more accurate picture of cash flow, and income is not subject to taxation until the money is actually received.
In contrast, the accrual basis makes a greater effort to recognize income and expenses in the period to which they apply, regardless of whether or not money has changed hands. Under this system, revenue is recorded when it is earned, rather than when payment is received, and expenses recorded when they are incurred, rather than when payment is made. The main advantage of the accrual method is that it provides a more accurate picture of how a business is performing over the long-term than the cash method. The main disadvantages are that it is more complex than the cash basis, and that income taxes may be owed on revenue before payment is actually received. However, the accrual basis may yield favorable tax results for companies that have few receivables and large current liabilities.
Under generally accepted accounting principles (GAAP), the accrual basis of accounting is required for all businesses that handle inventory, from small retailers to large manufacturers. It is also required for corporations and partnerships that have gross sales over $5 million per year, though there are exceptions for farming businesses and qualified personal service corporations—such as doctors, lawyers, accountants, and consultants. Other businesses generally can decide which accounting method to use based on the relative tax savings it provides.
Why Should I Tax Plan?
The main reason to tax plan is to ultimately have more money that you can either invest in new projects, save or even spend. Or do all three. The choice is yours.
There are more good reasons for tax planning.
- Strategic Tax Planning and Tax Management Can Lower Your Taxes
In the end, tax planning is all about reducing your tax bill. Keep in mind that tax planning:
- Is especially important if you own a business or if you are self-employed
- Makes sense if your investments have hefty unrealized losses or gains
- Is useful when you experience a major event in your life, such as getting married or divorced, having a baby, buying a home or retiring
- Is helpful if you move to a new job or sustain a significant change in your income, either up or down
- Can help you save money if you are sending one of your children to college for the first time
- Tax Planning Gives You Time to Strategize and Get the Most Out of Your Benefits
Too often, people wait until the very last second to try to use a tax benefit. While this works on occasion, effective tax planning requires that you allow for time to study the situation and make the appropriate decisions. Smart tax planning happens all year long, not on the last day of the year or the day before your taxes are due.
- Tax Planning Lets You Take Advantage of Changes the IRS Makes
Tax laws are always a little different every year. Very often, there are only minor changes, but after 2017, tax laws looked significantly different. Tax planning allows you to ready for these changes, whether minor or major, and make decisions about how you wish to deal with them and how they will affect your taxes.
- Tax Planning Helps You Avoid Deadline Dread
Regardless of changes the government makes to tax laws, decisions about how you want to deal with these changes and with your taxes every year have a firm deadline of midnight on April 15. Tax planning at the appropriate time means you are well prepared to deal with any contingency and in no danger of suffering deadline dread. A tax planning consultant ensures you are ready.
Types of Tax Planning
There are a few different types of tax planning that are useful for individual people, companies and organisations. Some of the tax plans include; short term tax plans, long term tax plans, permissive tax plans and purposive tax plans. The short term planning allows you to reduce taxes at the end of the income year. Long term plans allow you to plan at the end of the beginning or end of the year, permissive tax plans are permissible under different law provisions. The purposive tax plan gives you the chance to make different investments.
How It Works
When you start tax planning, you can find many guides online and you can also speak to financial advisors and solicitors to help get you started and give you all the important information that you will need to know. For example, each person has an inheritance tax allowance up to £325,000 with anything over the threshold being charged at 40%. So, if an estate was valued at £400,000, only £75,000 of that would be taxed. Since the majority of people won’t leave an estate over this amount, most feel they don’t need to know about inheritance tax. However, actively considering it and your future can help you to avoid any nasty surprises later on.
What Are Strategic Income Tax Planning Strategies for Individuals?
When you work with a tax or wealth advisor, you can develop strategies to reduce your tax bill, save money and plan for your future. Here are several tax strategies you might want to consider that reflect the importance of taxes for personal finance planning.
- Make the Most of Tax-Efficient Accounts
In most cases, this means taking advantage of retirement savings plans. Depending on which type of plan you choose, you can reduce your current tax bill or your future tax bill.
Whether you choose a traditional IRA, 401(k), a Roth IRA, or a Roth 401(k) they are all subject to limits on how much you can contribute. The amount is quite different between all four, and so it is smart to talk to a tax consultant about what might be the best plan for you.
Traditional 401(k)s and IRAs are the best idea when you want to defer taxes until later. Roth 401(k)s and IRAs are the best choices when you want an investment that offers you tax-free potential growth.
- Mix And Match Your Accounts
When you split your contributions among various types of accounts, whether they are retirement savings plans or brokerage accounts, you give yourself space to determine what your future taxes will be and how to deal with them. This is only possible if you take the time now to create different accounts that allow you to diversify your taxes.
- Reduce Your Taxable Income
Reducing your income does not mean you want to make less money every year. It does mean you take a look at strategies that could decrease your Adjusted Gross Income (AGI) by using effective tax strategies. This includes:
Putting contributions into retirement savings plans
Making donations to charity
Using investment losses to reduce your income
- Implement Personal Income Tax Planning Strategies for Investors
Everyone wants to invest wisely, of course, but there are specific investments that provide generous tax benefits. For instance, you do not pay federal taxes on municipal bonds, and that is often true of state and local taxes as well. Managers of taxed-manage mutual funds work hard to ensure they are tax efficient. There are many other types of similar investments you can make, so it is important to talk to your tax advisor to understand what the tax benefits may be connected to different kinds of investments.
- Connect Your Investments With the Right Type of Account
It does not make much sense to have tax-efficient investments if you are not putting them in the right place. You want to make sure your investments work with accounts that offer the best tax treatment. For instance, if you have investments like taxable bonds or stock funds that generate income, it is smarter to hold them in a tax-deferred account like a traditional IRA. This will give you the greatest potential benefits.
- Hold Onto Your Investments to Avoid Higher Capital Gains Taxes
Normally, it does not make sense to keep a stock that you want to sell only because you want to avoid taxes. Sometimes, however, you do want to hold off on selling an investment. For instance, if you sell stocks that you held for less than a year, they will be taxed at your ordinary income rate.
If you wait longer than a year to sell stocks, they are taxed with a long-term capital gains rate. In many cases, a long-term capital gain rate will be significantly less than your regular income tax rate. Before you decide to sell a stock, check with your tax advisor about tax implications.
- Employ Your Losses to Offset Your Gains
If you have any investment losses, use them to offset your gains on investments. Tax gain-loss harvesting can minimize your tax liability. If you lose more on your investments than you gain, you can then use those losses to offset as much as $3,000 of earned income in a single year. So if you make $50,000 a year, but you lost $3,000 in investments, your taxable income would only be $47,000. You can also carry additional losses forward.