Tax Planning: What It Is, How It Works, Examples

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Tax Planning: What It Is, How It Works, Examples

What Is Tax Planning?

Tax planning is the review of a financial condition or plan to ensure that all aspects work together to pay the least amount of taxes feasible. A tax-efficient strategy is one that reduces the amount of money you pay in taxes. Individual investors should include tax preparation in their financial plans. Reduced tax obligation and increased capacity to contribute to retirement plans are critical success factors.

Key Takeaways

  • Tax planning is the review of a financial condition or plan to ensure that all aspects work together to pay the least amount of taxes feasible.
  • Tax planning considerations include income timing, size, purchase timing, and spending planning.
  • Tax planning tactics may include IRA retirement savings or tax gain-loss harvesting.

Understanding Tax Planning

Tax planning encompasses a wide range of concerns. Considerations include income timing, purchase quantity and timing, and budgeting for other expenses. Furthermore, the choice of assets and kinds of retirement plans must match the tax filing status and deductions to get the best possible result.

Special Considerations

Saving via a retirement plan is a common approach to lower taxes. Contributing to a conventional IRA might reduce your gross income by the amount you contribute. For 2021 and 2022, assuming all conditions are met, a filer under the age of 50 may contribute up to $6,000 to their IRA and $7,000 if they are 50 or over.

For example, if a 52-year-old guy with a $50,000 yearly salary contributes $7,000 to a regular IRA and has an adjusted gross income of $43,000, the $7,000 contribution will grow tax-deferred until retirement.

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There are various alternative retirement options available to assist lower tax obligation. 401(k) programs are common among big corporations with numerous workers. Participants in the plan may transfer their earnings from their paychecks into the company’s 401(k) plan. The most significant distinction is that the contribution maximum cash amount is substantially larger than that of an IRA.

Continuing with the previous scenario, the 52-year-old might contribute up to $26,000 to their 401(k) (k).If you are under the age of 50, your salary contribution for 2021 may be up to $19,500 ($20,500 for 2022), or up to $26,000 ($27,000 for 2022) if you are 50 or older owing to the extra $6,500 catch-up contribution.

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.

As of 2021, long-term capital gains are taxedas follows:

  • Taxpayers earning less than $40,400 pay no tax ($80,800 if married filing jointly or an eligible widow(er), $54,100 if the head of the household, or $40,400 if married filing separately).
  • Single taxpayers earning more than $40,401 but less than $445,850 are subject to a 15% tax ($501,600 if married filing jointly or an eligible widow(er), $473,750 for the head of the household, or $250,800 for married filing separately).
  • Those whose income above the threshold for the 15% tax are subject to a 20% tax.
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In 2022, long-term capital gain limits will be increasing to the following:

  • 0% for taxpayers with an income of less than $41,675 ($83,350 for a combined return or widow(er), $55,800 for a person who is head of household, and $41,675 for anybody else).
  • 15% tax on income more than $41,675 but less than $459,750 ($517,200 for a combined return or widow(er), $488,500 for a person who is the head of a household, or $459,750 for any other individual)
  • Those whose income above the threshold for the 15% tax are subject to a 20% 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 21 of Schedule D (Form 1040 or 1040-SR) (Form 1040 or 1040-SR).

For example, if the 52-year-old investor had $3,000 in net capital losses for the year, the $50,000 income will be adjusted to $47,000. The remaining capital losses can be carried over with no expiration to offset future capital gains.

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