A significant drawback of financial success is how much more complicated one’s tax situation becomes. There are more numbers to track, issues to consider, and forms to file as you climb the income ladder, making it more challenging to ensure you only pay the IRS what is absolutely necessary and not a penny more.
The problem for most people is the tax code contains hundreds of tiny and often obscure provisions that can impact your financial circumstances. Without a clear understanding of how these provisions apply to your situation or proper planning to take advantage of what the tax code offers, it’s impossible to know if you’re paying too much in taxes, which can be detrimental to your wealth.
That’s where tax planning comes in—working with a financial professional to help you arrange your finances for maximum tax efficiency. It typically involves a detailed evaluation of your current financial situation, including income, expenses, and investments, and applying the provisions of the tax code, organizing them to minimize your tax liability while staying compliant with the tax code.
The goal of tax planning is to allow you to keep more of your earnings so you can use them to build your wealth—not by evading taxes, which is illegal, but by reducing your tax liability where possible within the scope of the law. Proper tax planning helps you identify opportunities to reduce tax liability through tax deductions, exemptions, credits, and other tax strategies.
ARQ Wealth’s wealth management services can help you . While we are not CPAs and do not file tax returns, we can help you maximize your tax savings with strategic planning. Give us a call at (480) 214-9572 or get in touch with our contact form.
Importance of Tax Planning
Tax planning is essential for several reasons:
Reducing Your Tax Burden
Tax planning is designed to help individuals and businesses reduce their tax liability by strategically using tax deductions, exemptions, credits, and income-shifting methods.
Maximizing Your Wealth
Throughout history, taxes have been one of the most significant impediments to building wealth. Effective tax planning can ensure you keep more of your earnings to make them available for investment or business expansion.
Keeping You Compliant
The tax code is complex, and it’s constantly changing. Expert tax planning ensures you remain compliant with the code to avoid penalties and legal consequences.
Transferring Your Wealth
If your plan is to leave a legacy, tax planning can reduce the impact of taxes on the transfer of wealth with strategies such as gifting assets or creating trusts.
Tax Efficient Investing
Not all investments are taxed the same. Understanding the tax implications of various investments can help you make smarter decisions on allocating assets for maximum tax efficiency.
Tax Diversification in Retirement
A big mistake many people make is to use tax-deferred vehicles such as a 401(k) plan or traditional IRA exclusively to save for retirement, only to realize the income generated by these plans is 100% taxable as ordinary income. Effective tax planning is essential for maximizing your retirement income using strategies like Roth IRA conversions or capital gains to minimize taxes and maximize cash flow in retirement.
Types of Tax Planning
Different types of tax planning can fulfill various needs and goals, such as:
Short-Term Tax Planning
The most common type of tax planning is done annually, usually before the end of the tax year. In most cases, it involves making adjustments that can impact how much you report as Adjusted Gross Income (AGI). It relies on strategies such as deferring income into the next tax year, accelerating expenses into the current tax year, making charitable contributions, or increasing contributions to your retirement plan.
Long-Term Tax Planning
For longer-term goals such as retirement, maximizing your estate, or business succession, tax planning focuses on strategies to help achieve them but can take several years to implement.
Permissive Tax Planning
Permissive tax planning involves using tax rules and provisions in a permissible way to reduce taxes. For example, the tax code permits you to take a tax deduction for mortgage interest.
Purposive Tax Planning
Purposive tax planning uses a broader, more strategic approach to reducing tax liability. For example, locating a business in a low-tax jurisdiction or timing the sale of stock to minimize capital gains are purposive tax planning strategies.
Business Tax Planning
Tax planning for businesses can reach a whole new level of complexity, involving how the business is structured, managing capital investments, timing of capital expenditures, and making other strategic decisions to minimize taxes.
Strategies for Effective Tax Planning
Tax planning has no one-size-fits-all strategy as everyone’s situation is unique with their income levels, personal or business circumstances, and where they live. Here are some of the more common tax planning strategies:
Income Deferral
You can lower your current year tax liability by deferring income to the next tax year. This is an effective strategy when you expect your marginal tax rate will be lower next year.
Income deferral can benefit retirees who can control when and how much income they receive from their investments, businesses expecting lower profits, or individuals who expect to fall into a lower tax bracket.
Maximizing Retirement Contributions
An effective way to reduce your tax liability is by contributing to your retirement accounts, such as a 401(k) or traditional IRA, as contributions. You are allowed to deduct the amount of your contributions to lower your AGI. The planning issue often comes down to whether to maximize your contributions for a bigger tax deduction.
Although you wouldn’t receive an immediate tax deduction, you might also consider whether you should contribute to a Roth IRA to diversify your income with tax-free withdrawals in retirement.
Claiming Deductions and Credits
The tax code offers a multitude of deductions and credits to incentivize certain financial behaviors or actions on the part of taxpayers. As a taxpayer, you should seek to claim all available deductions and credits. Deductions reduce your taxable income, while credits directly reduce your tax liability.
For example, you can deduct student loan interest, mortgage interest, and charitable contributions to reduce your AGI. Tax credits, such as the Child Tax Credit or Earned Income Tax Credit (EITC), provide a dollar-for-dollar reduction of your tax liability.
Tax-Efficient Investment Planning
Maximizing your investment returns from capital gains and investment income is critical for building wealth. Some of the common strategies include:
- Tax-loss harvesting: Selling investments at a loss to offset capital gains.
- Tax-exempt bonds: Interest from state and municipal bonds is often exempt from federal (and sometimes state) income taxes.
- Long-term vs. short-term capital gains: Holding investments for longer than one year qualifies for a lower capital gains tax rate compared to short-term gains, which are taxed at ordinary income rates.
Utilizing Tax-Free Savings Accounts
Utilizing tax-free savings accounts, such as Health Savings Accounts (HSAs) and 529 College Savings Plans, allows you to accumulate and use your funds tax-free if they’re used for qualifying medical or education expenses.
Contributions to an HSA are deductible, and withdrawals to cover eligible medical expenses are tax-free. Though contributions to a 529 plan are not deductible on the federal level, some states, like Arizona, offer a state income tax deduction. These plans can grow tax-free and be used to pay for eligible education expenses free of taxes.
Income Splitting
If you run a business, you can distribute more of your business income among family members in a lower tax bracket.
Estate Planning
The tax code offers numerous strategies for reducing estate taxes and preserving your assets for future generations. These include gifting strategies, setting up irrevocable trusts, trusts for maximizing the martial tax credit, charitable trusts, or creating a family foundation to pass on wealth while minimizing the tax impact on heirs.
Corporate Tax Planning
Business owners can access a number of strategies for reducing the tax burden on the business, including restructuring the business as an S- or C-Corp or Limited Liability Company (LLC), taking advantage of tax credits for R&D, or 100% bonus depreciation on equipment purchases.
If you operate a business internationally, you can benefit from strategies to establish operations in tax-friendly jurisdictions, manage cross-border transactions efficiently, and comply with international tax treaties.
Tools for Tax Planning
There is no shortage of tools and resources for planning your taxes. Your best option depends on your needs and circumstances.
- Tax software: Reasonably priced software programs like TurboTax, H&R Block, and QuickBooks help individuals and small businesses navigate tax planning by identifying deductions and ensuring compliance with tax laws.
- Financial advisors: For advice and guidance tailored to your particular situation, professional financial advisors and tax planners offer personalized tax planning services.
- Retirement calculators: Online calculators can help with retirement tax planning by showing how much you should contribute to tax-deferred accounts based on your income and retirement goals.
- Tax guides: The IRS publishes annual tax guides that outline changes to tax laws, deductions, credits, and other helpful information for tax planning. Many financial firms also offer free tax guides.
Challenges in Tax Planning
Despite all the tools and resources available, tax planning is still one of the most complex planning disciplines due to the breadth and intricacies of the tax code. The challenges of tax planning include:
- Complexity of Tax Laws: Tax laws are notoriously complex and constantly changing, making it difficult for individuals and businesses to stay current with the latest tax rules and optimize their tax planning strategies.
- Uncertainty: Long-term tax planning is a challenge due to uncertainty brought about by frequent changes in the tax code and changing tax brackets and income levels.
- Legal and Ethical Considerations: While tax avoidance is legal, aggressive tax planning strategies that push the boundaries of the law can lead to legal and ethical dilemmas. Taxpayers must strike a balance between minimizing taxes and adhering to both the spirit and letter of tax laws.
- International Tax Considerations: For multinational businesses, international tax planning can be incredibly complex due to differences in tax regimes, currency fluctuations, and cross-border tax treaties.
Bottom Line
On the financial planning spectrum, tax planning is one of the most critical disciplines because it has both an immediate and long-term impact on your finances and wealth. Proper tax planning seeks to organize your income, investments, and expenses in a way that will legally reduce your tax liability and positively impact your wealth.
However, it’s not enough to maximize your financial outcomes; it’s also critical to ensure you do it in compliance with the tax laws.
Unless the government comes up with a simplified tax structure like a flat tax, planning your taxes will continue to be a challenging endeavor. Understanding the nuances of the tax code, optimizing available deductions and credits, and aligning your tax strategies with your overall financial goals are the essence of tax planning, which may be beyond the reach of most people with neither the time nor inclination to develop the necessary expertise.
With so much at stake, financially and legally, it’s essential to seek the guidance of a qualified financial professional to help you navigate the challenges and ensure you’re not paying more taxes than necessary. ARQ Wealth Advisors is staffed with financial experts who provide top-tier tax planning and wealth management. Contact us for a free consultation.
