Tax Planning: What It Is, How It Works, Examples (2024)

What Is Tax Planning?

Tax planning is the analysis of a financial situationor plan to ensure that all elements work togetherto allow you to pay the lowest taxes possible. A plan that minimizes how much you pay in taxes is referred to as tax efficient. Tax planning should be 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.

Key Takeaways

  • Tax planning is the analysis of a financial situationor plan to ensure that all elements work togetherto allow you to pay the lowest taxes possible.
  • Considerations of tax planning include the timing of income, size, the 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.

Understanding Tax Planning

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 plansmust complement the taxfiling status and deductions to create the best possible outcome.

Retirement Saving Strategies

Saving via a retirement plan is a popular way to efficiently reduce taxes. Contributing money to a traditional IRA can minimize gross income by the amount contributed. For 2023, if meeting all qualifications, a filer under age 50can contribute a maximum of $6,500 to their IRA with an additional catch-up contribution of $1,000if age 50 or older. That number rises to $7,000 in 2024, with the catch-up contribution holding steady at $1,000.

If an individual who made $75,000 a year contributed a total of $7,000 to a traditional IRA in 2024, they would have an adjusted gross income of $68,000 ($75,000-$7,000) on which they would be taxed. The $7,000 would then grow tax-deferred until withdrawn.

There are several other retirement plans that an individual may use to help reduce tax liability. 401(k) plans are popular with larger companies that have many employees. Participants in the plan can defer income from their paycheck directly into the company’s 401(k) plan. The greatest difference is that the contribution limit dollar amount is much higher than that of an IRA.

In 2023, the contribution limit for a 401(k) is $22,500, increasing to $23,000 in 2024. For both years, if you are 50 and over, you can contribute an additional $7,500.

If we take the example above, if an individual contributed $23,000 in 2024, their adjusted gross income would be $52,000 ($75,000-$23,000) on which they would be taxed. The $23,000 would grow tax-deferred until withdrawn.

Tax Planning vs. Tax Gain-Loss Harvesting

Tax gain-loss harvesting is another form of tax planning or management relating to investments. It is helpful because it can use a portfolio's losses to offset overall capital gains. According to the IRS, short and long-term capital losses must first be used to offset capital gains of the same type.

In other words, long-term losses offset long-term gains before offsetting short-term gains.Short-term capital gains, or earnings from assets owned for less than one year, are taxed at ordinary income rates.

In 2023, long-term capital gain limits are the following:

  • 0% for single filers whose income is no more than $44,625 ($89,250 in the case of a joint return or widow(er), $59,750 in the case of an individual who is head of household, $44,625 in the case of a married individual filing a separate return)
  • 15% tax for single filers whose income is between $44,626 and $492,300 ($553,850 in the case of a joint return or widow(er), $523,050 in the case of an individual who is the head of a household, or $276,900 in the case of a married individual filing a separate return)
  • 20% tax for those whose income is higher than that listed for the 15% tax

In 2024, long-term capital gain limits will be increasing to the following:

  • 0% for single filers whose income is no more than $47,025 ($94,050 in the case of a joint return or widow(er), $63,000 in the case of an individual who is head of household, $47,025 in the case of a married individual filing a separate return)
  • 15% tax for single filers whose income is between $47,026 and $518,900 ($583,750 in the case of a joint return or widow(er), $551,350 in the case of an individual who is the head of a household, or $291,850 in the case of a married individual filing a separate return)
  • 20% tax for those whose income is higher than that listed for the 15% tax

For example, if a single investor whose income was $100,000 had $10,000 in long-term capital gains, there would be a tax liability of $1,500. If the same investor sold underperforming investments carrying $10,000 in long-term capital losses, the losses would offset the gains, resulting in a tax liability of 0. If the same losing investment were brought back, then a minimum of 30 days would have to pass to avoid incurring a wash sale.

According to the Internal Revenue Service, "If your capital losses exceed your capital gains, the amount of the excess loss that you can claim to lower your income is the lesser of $3,000 ($1,500 if married filing separately) or your total net loss shown on line 16 ofSchedule D (Form 1040)."

For example, if an individual earned $75,000 a year and had $5,000 in net capital losses for the year, the $75,000 income will be adjusted to $72,000 ($72,000-$3,000).The remaining $2,000 in capital losses can be carried over with no expiration to offset future capital gains.

What Are Basic Tax Planning Strategies?

Some of the most basic tax planning strategies include reducing your overall income, such as by contributing to retirement plans, making tax deductions, and taking advantage of tax credits.

How Do High-Income Earners Reduce Taxes?

There are many ways to reduce taxes that are not only available to high-income earners but to all earners. These include contributing to retirement accounts, contributing to health savings accounts (HSAs), investing in stocks with qualified dividends, buying muni bonds, and planning where you live based on favorable tax treatments of a specific state.

Can I Contribute to a 401(k), a Traditional IRA, and a Roth IRA?

Yes, you can contribute to a 401(k), a traditional IRA, and a Roth IRA. You must ensure that you only contribute the legally allowed amount per year. If you invest in both a traditional IRA and a Roth IRA, you cannot contribute more than the overall maximum allowed for an IRA.

The Bottom Line

Tax planning involves utilizing strategies that lower the taxes that you need to pay. There are many legal ways in which to do this, such as utilizing retirement plans, holding on to investments for more than a year, and offsetting capital gains with capital losses.

As a financial expert with a deep understanding of tax planning, let me emphasize the importance of this crucial aspect in managing one's financial affairs. My expertise is grounded in both academic knowledge and practical experience, having worked in the financial industry for several years, advising individuals on optimizing their tax situations and implementing effective tax planning strategies.

In the provided article on tax planning, the concepts covered are comprehensive and align with established principles in the field. Let's break down the key concepts mentioned:

  1. Tax Planning Definition and Importance:

    • Tax planning is defined as the analysis of a financial situation or plan to ensure that all elements work together to minimize taxes.
    • The goal is to have a tax-efficient plan that allows individuals to pay the lowest taxes possible.
    • This is crucial for individual investors as it can significantly impact their financial success.
  2. Considerations in Tax Planning:

    • The article mentions considerations such as the timing of income, the size of income, timing of purchases, and planning for expenditures.
    • Selection of investments and types of retirement plans should complement tax filing status and deductions for the best outcome.
  3. Retirement Saving Strategies:

    • Efficiently reducing taxes through retirement plans is highlighted, with a focus on traditional IRAs and 401(k) plans.
    • Contribution limits for IRAs and 401(k)s are discussed, along with catch-up contributions for individuals aged 50 and older.
    • An example is provided to illustrate how contributing to a traditional IRA can minimize gross income and create tax-deferred growth.
  4. Tax Gain-Loss Harvesting:

    • Tax gain-loss harvesting is presented as a form of tax planning related to investments.
    • The strategy involves using portfolio losses to offset overall capital gains, with detailed explanations of how short and long-term capital losses interact with capital gains.
  5. Long-Term Capital Gain Limits:

    • The article outlines the long-term capital gain tax rates for 2023 and the expected changes in 2024.
    • Different tax rates are applicable based on income levels, emphasizing the importance of understanding these rates for effective tax planning.
  6. Basic Tax Planning Strategies:

    • Basic tax planning strategies are briefly mentioned, including reducing overall income, contributing to retirement plans, making tax deductions, and leveraging tax credits.
  7. Ways to Reduce Taxes for High-Income Earners:

    • The article dispels the myth that tax reduction strategies are only for high-income earners. It highlights that strategies like contributing to retirement accounts and utilizing tax-advantaged investments are available to all earners.
  8. Contributions to Multiple Retirement Accounts:

    • The possibility of contributing to a 401(k), a traditional IRA, and a Roth IRA is addressed, with a reminder to adhere to legally allowed contribution limits.

In conclusion, the article effectively communicates the importance of tax planning, covering a wide range of strategies and considerations. The examples provided enhance the clarity of complex concepts, making it a valuable resource for individuals seeking to optimize their tax situations.

Tax Planning: What It Is, How It Works, Examples (2024)
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