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Tax planning 101: A full breakdown

At a glance:

  • What is tax planning all about?

  • How to reduce your taxable income

  • A closer look at adjustments to income

  • Reducing your applicable tax rate

  • Controlling the time when your tax must be paid

  • Summary of tax planning 101

  • Practical ideas you can start with today

The goal of tax planning is to arrange your financial affairs so as to lawfully minimize your taxes. This is called "tax avoidance," as opposed to "tax evasion," which is a crime.

There are a multitude of tax planning strategies, particularly if you own a small business. Some are aimed at one's individual tax situation, some at the business itself. Many are extremely sophisticated and specific in focus.

But regardless of how simple or complex a tax strategy is, its goal will be one or more of the following:

  • reducing your (or your business's) taxable income through investment strategy, deductions and tax credits

  • reducing your tax rate

  • delaying the time when you must pay the tax

What is tax planning all about? Here are the basics

Tax planning involves taking a pro-active approach to paying taxes.

While it is illegal to avoid paying taxes that you owe, there is nothing wrong with looking at your income and potential deductions in advance so as to pay the least amount of tax possible under the law.

There are a number of steps you can take to reduce your tax obligations, many of which involve saving for retirement, childcare, and medical expenses.

Why plan?

Income taxes on the federal level are a fact of life, and many people also have to pay state and local taxes.

When you make an effort to plan around taxes, you can save yourself money that you would otherwise pay to the federal, state or local governments.

While you may not notice the impact of federal taxes, they are the biggest expense that most families incur in the course of a year.

For example, if you save for retirement, whether in the form of an employer-based program such as a traditional 401k or individual retirement account (IRA) or both, you can save money on taxes.

You don't get a current tax deduction for contributions to a Roth 401k or Roth IRA, however.

Saving in a traditional 401k or traditional IRA reduces your taxable income when you make a contribution, but distributions are taxed.

While a Roth 401k and Roth IRA offers no deduction for contributions, but qualified distributions (including earnings) are not taxed.

Visible through a window, an H&R Block tax preparer (R) assists Senada Imsirovic (L) sitting next to her friend Kevin Schwaner, with her taxes. (Photo: Tim Boyle/Getty Images)
Visible through a window, an H&R Block tax preparer (R) assists Senada Imsirovic (L) sitting next to her friend Kevin Schwaner, with her taxes. (Photo: Tim Boyle/Getty Images)

Major tax planning

There are many areas of your financial life that can benefit from tax planning. Here are some of the ones that can pay off in the biggest ways:

  • Retirement contributions: Contributing to a retirement plan is one of the best ways you can save for your own future and save money on taxes.

    When you contribute to a traditional 401k plan at work, those contributions reduce your taxable income, so you will owe less tax at the end of the year. When you contribute to a traditional IRA, you also reduce your taxable income, as you will record how much you contributed on your tax form, and that may reduce your income.

  • Flexible spending account contributions: Contributions made to medical expense flexible spending accounts and dependent care flexible spending accounts are made through employers who offer them.

    These contributions are made on a pre-tax basis, so you save money on healthcare or dependent care-related expenses. Be aware that you must use all or most of your flexible spending account contribution in the year it was contributed or within a few months of year's end; otherwise, you will lose those balances.

  • Health savings account contributions: If you have a high-deductible health plan, you can deduct the contributions that you make.

    This has an additional benefit of not only saving you money on your taxes, but also helping you save for healthcare expenses and pay for those on a pre-tax basis.

  • Charitable donations: If you donate money to a church, social services organization or non-profit, and you itemize your deductions, you can save money if your itemized deductions exceed your standard deduction.

    It's important to document what you donate by obtaining a receipt from the charitable organization.

How to reduce your taxable income

Everyone's situation is different, and experts caution against making tax considerations the predominant factor in your financial decision-making process.

That said, there are a number of strategies and some basic information that you should be familiar with as you formulate a tax plan with your advisors.

Your investments

First, regarding your investments, recognize that there are many sound assets that will increase your wealth over the long haul, but which produce little or no current income.

Raw land or rental real estate that barely breaks even on a cash flow basis both can offer significant long-term appreciation in value.

The same is true of buy-and-hold growth stocks whose value you expect to increase over time, but which pay scant or no dividends. The same is true of good old U.S. savings bonds.

You can defer federal income taxes on your earnings (except for Series HH bonds) if you wait until the bond reaches final maturity or you cash it in.

Moreover, savings bonds are state and local income tax-free. Better yet, municipal bond interest is free from federal tax, and in most cases, free from tax in the state in which they are issued.

With any investment, it's also usually wise to plan your eventual sale more than a year after your purchase, so that any gain is considered a long-term capital gain.

As such, it will be taxed at a lower rate than will a short-term capital gain, which is taxed at your ordinary income rate.

Learn about deductions and credits

Another tax-planning approach is to reduce the part of your income that is subject to tax by taking full advantage of the many tax deductions and tax credits available to both businesses and individuals.

Some of these are very narrowly focused, while others apply to a much broader group of taxpayers. Consulting with a tax-planning professional is the best way to learn which deductions and credits are available to you.

The self-employed or small business owner, for example, may be able to take advantage of deductions for business meals and entertainment, automobile expenses, and business travel, among many others.

Also, there is a new 20% deduction for pass-through business income.

But there are always special rules that apply to these types of deductions, so again, the services of a tax professional can be invaluable.

For the moment, keep in mind the difference between a tax "credit" and a tax "deduction": A tax deduction reduces the amount of taxable income you have.

A credit reduces the actual tax you owe, within limits, usually dollar for dollar (e.g., a one-dollar tax credit reduces your tax bill by one dollar).

Sometimes, tax credits are refundable, which means you can get a check from the government if you owe no tax at all.

Clearly, tax credits are more valuable than deductions.

Itemized deductions

The most common itemized deductions are mortgage interest, charitable contributions and state and local taxes.

You should always take the higher of your standard deduction or your itemized deduction.

For 2020, the standard deduction is $24,800 for married couples filing a joint return; $12,400 for singles; and $18,650 for head-of-household taxpayers.

As of 2020, the mortgage interest deduction is limited to interest on acquisition indebtedness up to $750,000 (though grandfathering rules apply); and the state and local tax deduction, together with the property tax deduction, are limited to $10,000 ($5,000 for married taxpayers filing separately).

Nearly two out of three taxpayers, however, take the standard deduction — available to all — rather than itemizing.

In other words, they find that the standard deduction is larger than the total of all itemized deductions they would be able to take; given the large increases in the standard deductions in 2018, this option may become attractive to even more filers.

Thus, the standard deduction saves most people more on taxes.

Adjustments to income

You can also reduce your adjusted gross income through various adjustments to income. Adjustments are really a special class of deductions that you take on Schedule 1 of your Form 1040. They are traditionally called "above the line" deductions, and they reduce your adjusted gross income whether you choose to use the standard deduction or itemize your deductions.

A closer look at adjustments to income

Because adjustments to income are deductions that can be taken whether you itemize or take the standard deduction, they are especially important for all taxpayers to understand.

A full list of adjustments is found on Schedule 1 of Form 1040. The more important ones include:

IRA deduction

A great way for most people to increase their adjustments to income is to contribute to a traditional IRA.

An individual retirement account, or IRA, is a personal savings plan that allows you to set aside money for retirement, while reducing your taxable income and lowering your taxes as a result.

(Other retirement savings vehicles such as the 401k also reduce current taxes, but they are not deductions. Instead, these amounts are simply not included in current income to begin with.)

Contributions can be made to your IRA for a given year at any time during that year or by the due date for filing your return for that year (usually, April 15).

For complete information, see IRS Publication 590-A, Contributions to Individual Retirement Arrangements (IRAs).

For many people, saving for retirement is the best way to reduce current taxable income, although these funds are taxable when withdrawn years later.

Health savings account (HSA) deduction

An HSA may receive contributions from an eligible individual or any other person, including an employer or a family member, on behalf of an eligible individual.

Contributions, other than employer contributions, are deductible on the eligible individual's return whether or not the individual itemizes deductions. Employer contributions are not included in income.

Distributions from an HSA that are used to pay qualified medical expenses are not taxed.

See IRS Publication 969 for details.

Deductible part of self-employment tax

Self-employed people get to deduct the employer-equivalent portion of their self-employment tax, which is akin to the Social Security tax paid by those whose wages are paid by employers.

Use IRS Schedule SE to calculate the amount of the deduction.

Moving expenses

If you move to a new home because of a new principal workplace, you were able to deduct moving expenses up until 2017 (IRS Publication 521 provides details and restrictions).

You would have to meet both the distance and time tests. This deduction disappeared under the 2018 Tax Cuts and Jobs Act passed in late 2017, effective for 2018 onward.

Some exceptions remain for active-duty military personnel.

Self-employed health insurance deduction

If you were self-employed and had a net profit for the year, you can generally deduct, as an adjustment to income, amounts paid for medical and qualified long-term care insurance on behalf of yourself, your spouse, your dependents, and your children who were under age 27 at the end of the year.

If you were eligible to participate in an employer-sponsored health plan for any month, you may not include amounts you paid in that month.

Tuition and fees

Qualified education expenses represent a significant adjustment to income, reducing your taxes.

Generally, qualified education expenses are amounts paid for tuition and fees required for the student's enrollment or attendance at an eligible educational institution.

An eligible educational institution is virtually any accredited college, university, vocational school, or other postsecondary educational institution.

Consult IRS Form 8917 for details. This deduction often needs to be extended by Congress in order to apply. The various forms and publications are available at IRS.gov.

Reducing your applicable tax rate

Strictly speaking, one cannot actually lower his or her own tax rate. There are a limited number of steps and strategies, however, that have the same result, as a practical matter.

Shift it to a child

You can "shift" family income to a child. If it's possible and otherwise makes sense, consider hiring your child to work for you or your company.

As long as the child is paid a reasonable salary for work actually done, this is perfectly legal.

You can deduct the wages, and your child will report the income on his or her own tax return, at a tax rate that is (presumably) lower than yours. This is a good way to help you and your child pay for college, for example.

Another technique is to make your child a part-owner of your business, so that, again, the tax on his or her share of the profits will be taxed at a lower rate than yours.

Note that, unlike the wages paid to a child, this kind of income will be "unearned" and subject to the limitations described below.

You can also give some of your investments to your child, so that a portion of the investment income will be tax-free or taxed at his or her lower rate.

The first $1,100 of unearned income is generally tax-free; the next $1,100 generally taxed at the child's tax rate, and anything over $2,200 generally taxed at the higher rates applicable to estates and trusts.

These rules for taxing the child's unearned income are known as kiddie tax rules.

The kiddie tax

The kiddie tax generally kicks in when investment income in your dependent child's name is greater than $2,200.

The kiddie tax will be in effect until your child reaches age 19, or to age 24 if he or she is a dependent full-time student.

If your child is older than that, you can still place your investments in his or her name, but in that event, of course, those assets are not legally subject to your control.

The type of organization matters

Choosing the form of organization under which you do business also can help lower the applicable tax rate. The "regular" C corporation, for example, is itself a tax-paying entity, yet distributions from it (whether as salary or dividends) are taxed again to whoever receives them.

On the other hand, if you conduct business as a sole proprietorship or a "pass-through" entity (e.g., a partnership, limited liability company or S corporation), there is no tax at the entity level. Instead, income is taxed only once.

The 2018 Tax Cuts and Jobs Act, passed in late 2017, introduced a new deduction for pass-through business income. Taxpayers with pass-through businesses will be able to deduct 20% of their pass-through income.

For example, if your business earns $100,000 in profit, you will be able to deduct $20,000 of it before normal tax rates kick in.

The law uses phaseout income limits that apply to various "professional services" business owners. Given how new the law is, it may be wise for business owners to consult a tax professional for guidance.

Controlling the time when your tax must be paid

In broad terms, you can minimize taxes in the current year by postponing the receipt of income so that more of it will be taxed next year, and by accelerating deductions into the current year to reduce currently taxable income.

Assuming that you expect your tax rate to stay the same year to year — which is by no means always true — it's generally better to pay taxes later, because you'll then have the use of those tax dollars longer.

This kind of tax planning is primarily available to the self-employed and business owners; much less so to employees who work for wages.

What a businessperson can do

The business owner or sole proprietor can, for example, delay billings near the end of the year a bit, so that payments won't arrive (and be included in income) until early the next year.

Likewise, he or she probably has some financial flexibility to postpone year-end salary or dividend distributions until early the next year.

Conversely, business owners and sole proprietors should usually accelerate payments.

Consider prepaying in the current year those business expenses that can be deducted this year, such as rent, taxes, insurance, as well as operating expenses.

If practical, for example, pay for those repairs before year-end and buy that needed equipment or supplies now rather than early next year.

The same principle is true of larger, depreciable business property or real estate within the current year.

All of this assumes that the business uses the cash method of accounting.

What investors can do

Investors should usually plan to hold an asset for more than one year before selling it at a gain, in order that tax be paid at the favorable long-term capital gains rate.

If it is otherwise practical, it might also make sense to defer a planned sale from late in the current year until early the next year, if you expect a gain.

Contribute to a retirement plan

Of course, it almost always makes sense, if possible, to put in place a retirement plan such as a 401k and to make the maximum contributions allowed for the year.

Those contributions you make will be excluded from your income and will grow tax-deferred to build a nest egg.

Millennials aren't contributing as much to their retirement. (Graphic: David Foster/Cashay)
Millennials aren't contributing as much to their retirement. (Graphic: David Foster/Cashay)

Summary of tax planning

The goal of tax planning is to arrange your financial affairs so as to lawfully minimize your taxes.

We have looked at just a few of the multitude of tax planning strategies available, especially to those who own a small business.

Regardless of how simple or complex your tax strategy is, the goal will be one or more of the following: reducing your (or your business's) taxable income through investment strategy, deductions and tax credits, reducing your tax rate, and/or delaying the time when you must pay the tax.

Tax planning is such a complex field that, especially if you are self-employed or own a business, it's wise to at least consider working with a tax professional.

Practical ideas you can start with today

  • Begin by understanding the broad, fundamental goals of tax planning.

  • Examine your investment and business activities to identify specific areas where tax planning opportunities may arise.

  • Find a reputable tax professional to help you understand what specific steps could potentially minimize your tax bill.

  • Determine whether any possible planning opportunities make sense in the context of your overall financial situation and goals.

This content was created in partnership with the Financial Fitness Group, a leading e-learning provider of FINRA compliant financial wellness solutions that help improve financial literacy.

Read more information and tips in our Taxes section

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