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

What Is Tax Planning?

Tax planning is the analysis of a financial situation or plan to ensure that all elements work together to allow you to pay the lowest taxes possible. A plan that minimizes how much you pay in taxes is referred to as tax efficient. Tax planning should be an essential part of an individual investor's financial plan. Reduction of tax liability and maximizing the ability to contribute to retirement plans are crucial for success.

Understanding 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.

Retirement Saving Strategies

Saving via a retirement plan is a popular way to efficiently reduce taxes. Contributing money to a traditional IRA can minimize gross income by the amount contributed. For 2022, if meeting all qualifications, a filer under age 50 can contribute a maximum of $6,000 to their IRA with an additional catch-up contribution of $1,000 if age 50 or older. That number rises to $6,500 in 2023, with the catch-up contribution holding steady at $1,000.

For example, if a 52-year-old male with an annual income of $50,000 who made a $7,000 contribution to a traditional IRA has an adjusted gross income of $43,000, the $7,000 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 $27,000 into their 401(k) in 2022 (rising to $30,000 in 2023). That's because in 2022, if a person is under age 50, the salary contribution can be up to $20,500 ($22,500 for 2023), or up to $27,000 ($30,000 for 2022) if age 50 or older due to the allowed additional $6,500 catch-up contribution. The catch-up contribution for 2023 rises to $7,500.

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 2022, long-term capital gains are taxed as follows: 

• 0% for single filers whose income is no more than $41,675 ($83,350 in the case of a joint return or widow(er), $55,800 in the case of an individual who is head of household, or $41,675 in the case of a married individual filing a separate return)
• 15% tax for single filers whose income is between $41,676 and $459,750 ($517,200 in the case of a joint return or widow(er), $488,500 in the case of an individual who is the head of a household, or $258,600 in the case of a married individual filing a separate return)
• 20% tax for those whose income is higher than listed for the 15% tax

In 2023, long-term capital gain limits will be increasing to the following:

• 0% for single filers whose income is no more than $44,625 ($89,250 in the case of a joint return or widow(er), $59,750 in the case of an individual who is head of household, $44,625 in the case of a married individual filing a separate return)
• 15% tax for single filers whose income is between $44,626 and $492,300 ($553,850 in the case of a joint return or widow(er), $523,050 in the case of an individual who is the head of a household, or $276,900 in the case of a married individual filing a separate return)
• 20% tax for those whose income is higher than that listed for the 15% 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).

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.