What is 'Tax Planning'
Tax planning is the analysis of a financial situation or plan from a tax perspective. The purpose of tax planning is to ensure tax efficiency, with the elements of the financial plan working together in the most tax-efficient manner possible. Tax planning is an important part of a financial plan, as reducing tax liability and maximizing eligibility to contribute to retirement plans are both crucial for success.
BREAKING DOWN 'Tax Planning'Tax planning encompasses many different considerations, including the timing of income, purchases and other expenditures; the selection of investments and types of retirement plans; and a person's filing status and common deductions.
Saving using a retirement plan is a very popular way to efficiently reduce taxes. Contributing money into a traditional IRA can reduce a person’s gross income amount up to $6,500 if all qualifications are met. For example, if a 52-year-old male with an income of $50,000 a year made a $6,500 contribution to a traditional IRA, his adjusted gross income would now be $43,500. The $6,500 would be invested and grow tax-deferred until retirement.
There are several other retirement plans that individuals can 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 biggest difference is that the contribution limit amount is much higher than that of an IRA. In the same example, the 52-year-old could contribute up to $24,000 of salary and reduce his adjusted gross income to $26,000.
Tax Loss Harvesting
Tax loss harvesting is another way of tax management in relation to investments. When an investor sells a stock for a profit, capital gains need to be paid. As of 2016, if the holding period was more than one year, then a 15% capital gains tax will be levied. Anything less than one year holding will be issued at the investor’s tax bracket. Tax loss harvesting is useful because it can use losses in the portfolio to offset those capital gains. For example, if an investor had $10,000 in long-term capital gains for the year, there would be a tax liability of $1,500. However, if the investor was able to sell the losing investments that totaled $10,000 in losses, the capital gain would be offset to $0. If the same losing investment were bought back, then a minimum of 30 days would have to pass to avoid incurring a wash sale.
Even if there are no capital gains during the year, investors should still consider selling losing positions. Capital losses can be carried over for future use with no expiration, and these can be used to offset any future capital gains. Another benefit to selling losing positions is that $3,000 can be used to reduce ordinary income. So if the 52-year-old investor had at least $3,000 in net capital losses for the year, the $50,000 income will be reduced to $47,000.