If you’re like many people, you put off filing your taxes until the due date is about to fall on your head. We get it—taxes can be a major source of stress, but they don’t have to be! With effective tax planning, you may be able to reduce your tax payable or secure a larger refund at the end of the year. On the other hand, failing to plan and understand your taxes may leave you missing out on potential benefits and paying more than you need to. American taxpayers are facing a long list of tax changes for the 2022 tax year, so it’s smart to start planning for them now.
This article outlines what tax planning is, its potential benefits, and how to get started.
What is tax planning?
Tax planning has a simple definition: it is the process of analyzing your financial situation to help you minimize your tax liability; i.e. to owe less. It’s an essential part of financial planning for really any taxpayer, including individuals, families, and businesses. As a general rule of thumb, the more complex your tax return, the greater the opportunities in tax planning.
Popular tax planning strategies include:
- Accounting for tax credits and deductibles
- Understanding which tax bracket you fall into
- Making strategic purchases to minimize tax liability
- Bunching deductions into a calendar year in order to gain the greatest benefit
Why is tax planning important?
Depending on your situation, tax planning has the potential to result in hundreds (or even thousands) of dollars in your pocket. As you create your financial plan, it’s important to anticipate taxes as part of any wealth management strategy.
Effective tax planning can help you:
- Draft a thorough tax-minimization plan to reduce your tax liability
- Save for your child’s education
- Save towards your retirement fund
- Grow your small business
- Maximize your income
- Protect you from legal penalties
Proper planning helps you to understand tax benefits
If you’re eligible, there are several tax benefits you might be able to take advantage of:
- Deductions: Tax deductions are usually expenses incurred throughout the year, which you can subtract from your total income, allowing you to reduce your taxable income. For example, if you’re self-employed, there are a number of tax deductions available to you.
- Rebates: Rebates are a form of tax refund that occur after a retroactive tax decrease. For example, rebates can be used to help stimulate the economy or incentivize environmentally friendly practices.
- Credits: Credits allow you to subtract from the total tax you owe. Students, low-income families, or families with dependents may qualify for a tax credit.
- Exemptions: Exemptions reduce someone’s responsibility to pay taxes. For example, dependent-related exemptions allow you to reduce your taxes for each child or other relative under your care.
Tax brackets and taxable income
Your tax planning process should start by identifying your tax bracket, which will dictate the rates at which various percentages of your taxable income will be taxed. The IRS has determined the following seven tax brackets of an individual’s income: 10%, 12%, 22%, 24%, 32%, 35%, and 37%. Your income level dictates your tax bracket; the lower your taxable income, the lower your tax rate.
It’s important to note that, because the IRS allows you to adjust for certain tax deductions, your taxable income is usually lower than your overall income. The amount left over after deductions counts as taxable income.
What’s the difference between tax credits and tax deductions?
A tax credit reduces your final tax bill, dollar-for-dollar. Unlike deductions and exemptions, which reduce your taxable income, every tax credit (measured in dollars) allows you to save a dollar’s worth of your tax due. For example, if you have tax credits amounting to $300, you’d deduct $300 from your total tax owed.
A tax deduction, on the other hand, lowers the amount you’ll be taxed on (taxable income) and reduces your tax liability in a different way than a credit. The lower your taxable income, the lower your tax bill, but a $300 tax deduction does not reduce your tax owed by $300.
A tax preparer can help you identify whether you’d benefit from itemizing your deductions; the TCJA made this a much less popular option, but some high earners may still benefit in certain years. It’s also worth noting that some deductions are above the line, which means that even those who take the standard deduction can still benefit.
Now that you understand the basics, you may want to talk to a professional CPA
Without proper tax planning, you may end up paying more than necessary come tax time. A professional tax practitioner will be able to provide specialized tax planning services to help you make beneficial financial decisions. Consulting with an expert as part of your tax planning process can help you maximize your earnings, minimize your tax liability, avoid legal penalties, and even plan for a college fund or retirement.
Get in touch with our team so we can help you reduce tax-related stress and create a plan that serves your specific needs and financial objectives.