What Is Income Tax Planning?
What Is Tax Planning?
Tax planning is the analysis of a financial situation or plan from a tax perspective. The purpose of tax planning is to ensure tax efficiency. Through tax planning, all elements of the financial plan work together in the most tax-efficient manner possible. Tax planning is an essential part of an individual investor’s financial plan. Reduction of tax liability and maximizing the ability to contribute to retirement plans are crucial for success.
How Tax Planning Works
Tax planning covers several considerations. Considerations include timing of income, size, and timing of purchases, and planning for other expenditures. Also, the selection of investments and types of retirement plans must complement the tax filing status and deductions to create the best possible outcome.
- Tax planning is the analysis of finances from a tax perspective, with the purpose of ensuring maximum tax efficiency.
- Considerations of tax planning include timing of income, size, timing of purchases, and planning for expenditures.
- Tax planning strategies can include saving for retirement in an IRA or engaging in tax gain-loss harvesting.
Steps Needed for Effective Tax Planning
Ok, tax planning is important. But how can you set up your company in order to take advantage of this planning? Below are five steps needed to create a system of efficient tax analysis.
Bookkeeping – Make sure your startup has a good bookkeeping system in place. There’s been an explosion in the types of accounting software available, especially for SaaS startups. It used to be that companies would be forced to buy QuickBooks and use it exclusively. While Quickbooks is still the industry standard, it’s not for everyone, and companies can now use is FreshBooks, which is made suited for very small businesses and sole proprietorships, and Xero, for larger businesses.
Getting the right accounting software is important because you’ll conduct all your tax planning analysis from the reports it provides.
Certified Accountant – Establish a relationship with a reputable and certified accountant. In the United States, there’s a job title called a Certified Public Accountant (CPA), and the CPA designation is a standard for a reliable accountant. Find an accountant you trust and meet with them to discuss which bookkeeping software is right for you and get advice about how to efficiently structure your taxes for your business. These accountants will also help with the actual filing of your taxes.
Use a Company Card – This is the best way to separate your business and personal spending. When you’re planning for your taxes, you’ll need to identify company income and expenses, and then strategies on ways to lower your tax liability. If you’re personal and company transactions are mixed, you won’t be able to do this.
If you do end up paying a vendor or making a business purchase with your personal credit card, make sure to keep track of it as an out-of-pocket expense. Don’t wait to take note of it, otherwise you’ll forget about it and won’t get to claim the expense.
Set up a Retirement Plan – Retirement plans are tax deductible and can help minimize a company’s tax burden. Also, young entrepreneurs are often cash-starved and aren’t thinking about their future. Setting up a retirement plan has the added benefit of helping business owners plan for retirement all while reducing the amount of business taxes they pay.
Earmark Money for Taxes – Make sure you’re putting money aside in order to pay future taxes. A lot of startups fail to do this and end up using future earnings to pay for past taxes. It’s a vicious cycle, and one that’s hard to stop.
Income Tax Planning
Income taxes are an important component for clients to consider as we work together through the planning process. This resource is provided to help clients understand current federal income tax laws and ways to reduce income tax exposure.
It is important to understand the income tax laws that apply to individuals. The following information regarding individual income tax laws is intended to educate you on your exposure to income tax liability and potential tax-savings opportunities.
Income, Deductions and Credits
Personal Income and Tax is designed to help you understand how income tax applies to individuals, and Personal Deductions and Credits helps you evaluate whether you are using some of the deductions and credits available to reduce income tax liability.
Certain retirement savings vehicles are available to enable you to plan for retirement in a tax-efficient manner. Utilizing Retirement Planning to Reduce Income Tax can help you determine if you are saving for retirement in the most tax-efficient manner, and the Required Minimum Distribution tool can help you assess what income must be distributed from certain qualified retirement plans once you reach age 72.
Deferring Tax Upon the Disposition of Real Estate describes how 1035 exchanges can be used to reduce current income tax liability for certain taxpayers.
For clients with a charitable objective, Utilizing Charitable Giving to Reduce Income Tax and Conservation Easements provides preliminary information on how to provide for charity in a tax-efficient manner.
An understanding of income tax is a necessary component of ensuring a business is operating efficiently and effectively. Recent changes to the law have drastically impacted how businesses are taxed and created some tax saving opportunities for businesses and business owners. The following is intended to educate you on the income tax liability your business may be exposed to as well as options that may exist to reduce your business’s exposure to income tax liability.
Deductions and Credits
Business Deductions and Credits and Tax Benefits of Research and Development can help you evaluate whether your business is utilizing available deductions. Will Your Pass-Through Benefit from the Reduced Business Tax Rate provides an overview of how the new tax law may impact your taxes, and the Qualified Business Income Estimator helps to calculate whether you might benefit from the new law.
Taxation of Business Entities provides an overview of how a business’s entity selection can impact taxes. How are C Corporations Taxed? and How are Pass-Through Entities Taxed? provide more detail to help you consider the income tax attributes of your business.
An efficient structure can significantly reduce the employment taxes that a business must pay. Using a Common Paymaster to Reduce Taxes provides information on how employment taxes can be reduced for some business owners.
Strategies to Consider
You don’t want to pay more in federal income tax than you have to. With that in mind, here are five things to consider when it comes to keeping more of your income.
- Postpone your income to mitigate your current income tax liability
By deferring (postponing) income to a later year, you may be able to mitigate your current income tax liability and invest the money that you’d otherwise use to pay income taxes. And when you eventually report the income, it’s possible that you’ll be in a lower income tax bracket.
Certain retirement plans can help you postpone the payment of taxes on your earned income. With a traditional 401(k) plan, for example, you contribute part of your salary into the plan, paying income tax only when you later withdraw money from the plan (withdrawals before age 59½ may be subject to a 10 percent penalty tax in addition to regular income tax, unless an exception applies). This allows you to postpone tax on part of your salary and take advantage of the tax-deferred growth of any investment earning
There are many other ways to postpone your taxable income. For instance, you can contribute to a traditional IRA, buy permanent life insurance (the cash value part grows tax deferred), or invest in certain savings bonds. You may want to speak with a tax professional about your tax planning options.
- Shift income to family members to lower the overall family tax burden
You may also be able to mitigate your federal income taxes by shifting some income to family members who are in a lower tax bracket. For example, if you own stock that produces dividend income, one option might be to gift the stock to your children. After you’ve made the gift, the dividends will represent income to them rather than to you, potentially lowering your family’s overall tax burden. Keep in mind that you can make a tax-free gift of up to $14,000 (the $14,000 limit applies to 2016 and 2017 and could increase in future years) per year per recipient without incurring federal gift tax.
However, look out for the kiddie tax rules. Under these rules, for children under age 18, or children under age 19 (or full-time students under age 24) who don’t earn more than one-half of their financial support, any unearned income over $2,100 (in 2016 and 2017) is taxed at the parent’s marginal tax rate. Also, be sure to check the laws of your state before giving securities to minors.
Other ways of shifting income include hiring a family member for the family business and creating a family limited partnership. Be sure to investigate all of your options carefully before acting.
- Deduction planning involves proper timing and control over your income
Part of mitigating federal income tax is about taking advantage of all deductions to which you are entitled, and timing them in the most beneficial manner.
As a starting point, you’ll have to decide whether to itemize your deductions or take the standard deduction. Generally, you’ll choose whichever method lowers your taxes the most. If you itemize, be aware that some deductions (for example, medical and miscellaneous expenses) are allowed only to the extent the deduction exceeds some percentage of your adjusted gross income (AGI). Also, an overall limitation on itemized deductions may apply to individuals with high AGIs. In cases where your deductions are affected by your AGI, you might look at ways to potentially increase your allowable deductions by reducing your AGI. To lower your AGI for the year, you can defer part of your income to next year, buy investments that generate tax-exempt income, and contribute as much as you can to qualified retirement plans.
Because you can sometimes control whether a deductible expense falls into the current tax year or the next, you may have some control over the timing of your deduction. If you’re in a higher federal income tax bracket this year than you expect to be in next year, you’ll want to consider accelerating deductions into the current year. You can accelerate deductions by paying deductible expenses and making charitable contributions this year instead of waiting until next.