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. Through tax planning, all elements of the financial plan work together in the most tax-efficient manner possible. Tax planning is an essential part of a financial plan. Reduction of tax liability and maximizing the ability to contribute to retirement plans are crucial for success.

BREAKING DOWN '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 plans must complement the tax filing status and deductions to create the best possible outcome.

Tax Planning for Retirement Plans

Saving via a retirement plan is a popular way to efficiently reduce taxes. Contributing money to a traditional IRA can minimize gross income up to $6,500. As of 2018, if meeting all qualifications, a filer under age 50 receives a reduction of $5,500 and a reduction of $6,500 if age 50 or older. For example, if a 52-year-old male with an annual income of $50,000 who made a $6,500 contribution to a traditional IRA has an adjusted gross income of $43,500, the $6,500 contribution would grow tax-deferred until retirement.

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. 

Using the same example as above, the 52-year-old could contribute up to $24,500. As of 2018, if under age 50, the salary contribution can be up to $18,500, or up to $24,500 if age 50 or older. This 401(k) deposit reduces adjusted gross income from $50,000 to $25,500.

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. As of 2018, short-term capital gains, or earnings from assets owned for less than one year, are taxed at ordinary income rates. 

Long-term capital gains are taxed based on the tax bracket in which the taxpayer falls. 

  • 0% tax for taxpayers in the lowest marginal tax brackets of 10% and 15%
  • 15% tax for those in the 25%, 28%, 33%, and 35% tax brackets
  • 20% tax of those in the highest tax bracket of 39%

For example, if an investor in a 25% tax bracket 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.  

Up to $3,000 in capital losses may be used to offset ordinary income per tax year. 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.  Remaining capital losses can be carried over with no expiration to offset future capital gains.

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