tax planning and common misconceptions

When it comes to taxes, it really does pay to have a tax strategy. Let’s explore what tax planning is and a couple of the most common misconceptions.

What is tax planning?

Tax planning is a process in which we use projections surrounding current and future income levels, financial activities, and tax regulations to determine a strategy to reduce your overall tax burden or to target a reduced tax burden in specific years.

In general, we try to take income when it will be subject to a lower overall tax. This means either timing the income for a year in which you will be subject to a lower tax rate or taking whatever steps are legally available to you to reduce your effective tax rate in a given year.

Common Misconceptions About Tax Planning

Misconception #1: Tax planning is illegal

A common misconception seems to be that tax planning is illegal—that the 75,000+ pages of the tax code and tax guidance issued by the IRS simply apply to everyone in the same manner and that if you take any steps to avoid that, you are committing fraud or some other crime.

Perhaps one reason contributing to this misconception is when tax preparers, including myself, say that you can’t do much to reduce last year’s tax bill. By the time we prepare your tax return, we are essentially reminding you of the income you already earned.  The IRS already knows about much of your income (through W-2, 1099, and other forms) and we’re notifying the IRS about the income they didn’t already know about (asset sales, unreported income, etc.)

Your tax return is also your opportunity to tell the IRS about all the deductions and credits for which you qualify. Based on all your income and all of your deductions and credits, we calculate your final tax liability and “true-up” your account with the government by letting them know where to send the refund or by sending them a check.

When we prepare your tax return, we report on what has already happened—you earned income, you deferred income, you sold a house, you withheld taxes, etc. There are very few opportunities to make choices on your tax return about how to report activities that already took place. Therefore, you can’t do much now to reduce last year’s tax bill.

Tax avoidance vs. tax evasion

Tax planning is not illegal. The key thing to note here is that there is a difference between tax avoidance and tax evasion. Tax avoidance is taking steps to avoid incurring a tax in the first place. Tax evasion is taking steps to avoid paying a tax that you’ve already incurred. Tax planning is tax avoidance.

common misconceptions about tax planning

Examples of tax planning strategies

  • You probably participate in at least one method of tax avoidance now. For instance, if you participate in a retirement account, whether individual or employer-sponsored, you are avoiding taxes. If you contributed on a pre-tax basis, you are avoiding taxes currently. Contributing on a Roth basis, then you are avoiding taxes in the future.
  • If we adjusted your 401k contributions during the year or perhaps shifted some of your contributions to a Roth plan rather than a pre-tax plan, we engaged in tax planning to lower your tax bill either now or in the future.
  • Or, perhaps you wanted to sell the house that you moved into on July 6, 2021 and had significant capital gains built into the selling price. As a result of tax planning, we might recommend completing the sale after July 6, 2023. This could save you from paying capital gains taxes on up to $250,000 of gains (assuming you’re single) because you lived in the house for two out of the last five years.
  • When we do tax-loss harvesting on your taxable investment accounts during the year, we’re managing your tax bill.
  • As a business owner, when you accelerate equipment purchases or other expenses in a high-income year to lower your tax bill for this year or maintain eligibility for a tax credit or deduction, we’re doing tax planning. By the same token, when we intentionally defer business expenses or income until next year it is often the result of tax planning.

One of the most impactful strategies for tax planning involves spreading your income over a longer period of time to reduce particularly high-income and, therefore, high-tax years. With this strategy, we attempt to shift some income from those high-income years to years when taxable income may be lower, subjecting less income to your highest marginal tax rate. This strategy may involve participating in deferred compensation plans, bunching charitable contributions, using a Donor Advised Fund, or using installment sales for a business sale.

In some cases, this even involves spreading income over family members. Shifting ownership shares in your business to family members who are in lower tax brackets can reduce the overall tax burden on the family as a whole.

Misconception #2: Tax planning doesn’t make a difference because you’ll pay the taxes eventually

As you’ve read above, much of tax planning involves changing the timing of income and, therefore, the timing of taxes. So, it is understandable that some people feel that it’s all just a question of when you pay the taxes; all of the income will eventually be taxed. But first, if you plan properly, not all of the income will be taxed. Second, tax planning can help you ensure that some of that income is taxed at a lower rate.

Not all income needs to be taxable, and some income could be taxable at 0%. If you contribute to Roth retirement accounts, and your withdrawals from your Roth accounts meet the requirements, the portion of the withdrawal that is growth can be withdrawn tax-free and you already paid taxes on the portion that you initially contributed. Roth accounts are one of the most important tools for tax planning in retirement. Since the withdrawals aren’t considered taxable income, they don’t increase your tax rate. And, possibly more importantly, those funds do not count when determining the amount of any Income Related Monthly Adjustment Amount (IRMAA), otherwise known as the Medicare surcharge (which can be hefty).

In addition, the long-term capital gains rate is 0% if your taxable income is less than $94,050 (Married Filing Jointly in 2024). Just as a quick example, assume you’re over 59 ½ and meet the other requirements for qualified withdrawals from your Roth IRA. If you take a $40,000 distribution from your Roth IRA as well as $123,250 in long-term capital gains, you could have $163,250 in income and pay $0 in federal income taxes (in 2024, assuming the standard deduction). This is an extreme example, as you probably wouldn’t want to use up your Roth this way (when we do your tax planning, you’ll understand why). But, you can see how deferring your income with your Roth account and ensuring that you had long-term capital gains available to take as income could allow you to pay $0 in taxes on that income that year. If that income had been earned income or short-term capital gains or withdrawals from a pre-tax retirement account, the tax bill would be very different. However, being able to take advantage of this situation involves planning and taking steps well in advance.

Tax Planning for Small Businesses

Tax planning for small business owners also adds a degree of complexity but potentially greater savings. Factors to consider include business organization type, S Corp elections, allocations of income and expenses, and purchases and sales of equipment and assets. In addition, the sale of the business itself should involve tax planning to manage the overall tax bill associated with the capital gain from the sale.

Tax Planning and Estate Planning

And, finally, planning for estate taxes can make a big difference in the amount of your wealth that is passed on to your heirs versus the amount paid to the government. Combining your income tax and estate tax planning can help preserve your assets and ensure that they are ultimately distributed as you intend.

These are common examples of income tax planning. Executive compensation plans, gifting and charitable donations, and sales of highly appreciated business interests and real estate, just to name a few areas, add additional complexity. If any of these situations apply to you, we recommend you seek help from a financial advisor who can help you understand your options and then craft a plan to reduce your overall long-term tax burden. Working with a tax-aware financial advisor provides other benefits like letting you know which tax forms to expect – making tax time go more smoothly.

This article is intended to be educational and thought-provoking rather than financial advice. When we work together in a financial planning engagement, we discuss your unique personal situation and your unique goals. We examine these factors and many others during our financial planning process to determine appropriate financial strategies for YOU.

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