Tax Planning for Beginners: Definition, Effective Strategies & Tips

Tax planning is a strategic method of analyzing your finances to assess how to lower the total amount of taxes that you owe.

It is an integral part of ensuring you maximize your earnings, avoid underpaying your taxes, and still have enough disposable income left after filing your returns.

In this article, we’ll explain everything you need to know about tax planning, including the different types of tax planning and some effective tax planning strategies that you can use later on.

Key Takeaways

• The meaning or definition of tax planning is that it is a type of financial analysis that aims to reduce one’s tax dues and have more disposable income left as a result.
• An effective tax planning method entails having clear objectives, knowing which types of taxes to focus on, and getting started at the soonest possible time.
• Some of the key benefits of tax planning include increasing taxpayer’s savings, securing their properties, helping them address existing tax liabilities, and enhancing their retirement plan.

Understanding the Basics of Tax Planning

The basics or importance of tax planning lie in helping taxpayers fulfill their tax obligations consistently while also figuring out how to make it so that they can gain higher returns or refunds over time.

There are three key factors of tax planning that you should know, and these are:

#1. Tax Planning Objectives

The first factor to consider is your tax planning objectives. Aside from reducing your tax burdens, you can also ensure better tax compliance, especially if you own a business.

Carefully planning how you streamline your tax duties also means keeping your records organized, accurate, and up-to-date at all times.

It is crucial to point out that there is a clear difference between tax planning vs. tax avoidance. The former is done to save on taxes, while the latter is a deliberate plan to avoid or disregard one’s tax obligations.

#2. Types of Taxes

There are different types of taxes to consider when establishing a tax planning strategy that works for your finances, such as:

• Federal income tax. This type of tax is levied on employee wages and salaries, including dividends, commissions, and capital asset profits.

• Estate tax. Also called the ‘death tax,’ it is a one-time tax levied on the transfer of a deceased person’s assets that are worth more than $13.61 million.

• Small business tax. As its name implies, it is a tax imposed on small business owners. It comprises other types of taxes, such as state and local taxes, excise tax, sales tax, and employment tax.

• Capital Gains tax. It is levied on profits earned from selling real estate and other types of properties or assets.

#3. Timing

The best time to get started with tax planning is now. The more you delay your tax planning strategy, the more time and opportunities to reduce your taxable income you waste.

Remember, tax planning is a continuous process, and you can gradually improve or tweak your existing strategy to suit your budget and monetary goals.

5 Benefits of Tax Planning

Some of the main benefits of tax planning include helping taxpayers boost their savings and protect their assets in the long run.

Let’s take a closer look at each of these advantages:

#1. Boost in Savings

Tax planning for individuals is a useful skill that can prove useful for short and long-term monetary objectives. Depending on an individual’s tax bracket, paying taxes can truly take a huge percentage of someone’s hard-earned money.

Economic changes can also cause price increases for basic necessities, making it even more difficult for people in low and middle-income households to budget their finances.

But, by figuring out which tax write-offs and credits to apply to their taxes, they can set aside more money to build a college fund, purchase a property, pay off debts, or cater to their family’s basic needs.

#2. Property Retention

Estate taxes can potentially depreciate an estate or asset’s value, especially if a high amount of tax is levied on the property owner’s income. Taxpayers passing on inheritance or wealth to their descendants can implement a tax plan to reduce their estate taxes.

On the other hand, there are tax planning strategies such as establishing an asset protection trust or a charitable trust that effectively maximize their asset’s value. A tax planning strategy is also instrumental in reducing the taxes on their heir’s properties and inheritance.

#3. Ensure Full IRS Compliance

Tax planning is not just about reducing one’s federal income taxes or determining applicable tax credits and deductions. It also requires an understanding of how different regulations work for specific types of taxes and taxpayers.

For instance, if you own a business, it would be advisable to understand how the IRS levies taxes on your profits and know the proper tax treatment for W-2 employees and 1099 contractors.

Similarly, if you’re self-employed, you must become familiar with the different tax deductions for independent contractors and when it is best to apply them to your taxes.

#4. Resolve Tax Liabilities

An efficient tax planning strategy comes in handy when figuring out how to file taxes with no income.

Planning how to fulfill your tax obligations allows you to explore alternative options offered by the IRS to pay off any tax debt and penalties that you incur.

#5. Save More For Retirement

You can increase your retirement account contributions by the time you reach the age of 50.

At the same time, some retirement plan contributions become tax-free after a certain period. As such, assessing how you can contribute more without compromising your tax obligations early on increases your chances of looking forward to a more fruitful retirement in the future.

5+ Tax Planning Strategies

When choosing a tax planning strategy, choose one that’s readily available to you to save time and resources.

Enumerated below are six of the most trusted and effective methods of tax planning:

#1. Contributing to Retirement Plans

Traditional IRAs and 401k plans are tax-deferred accounts, meaning your contributions reduce your taxable income on a dollar-for-dollar basis. At the same time, all pretax contributions to these plans are not taxed until you reach retirement.

On the other hand, Roth accounts such as Roth 401(k) and Roth IRA do not reduce taxable income but do not levy additional taxes on income and withdrawals for as long as you take out your contributions after retiring.

#2. Estate Planning

Federal estate taxes can go as high as 40%,depending on the type of property and assets that you own.

One way to reduce your estate taxes is to move your assets from your taxable estate. You can do this by creating an irrevocable trust that’s under the supervision of a trustee.

In this manner, you can protect your properties from the possible decrease in value caused by excessive estate taxation. An irrevocable trust also lets your descendants claim life insurance policy proceeds upon your death.

Other estate tax planning methods you can try include setting up a qualified personal residence trust (QPRT), which lets you move ownership of your residential property to a trust to reduce your estate taxes.

#3. Managing Capital Gains

If you own real estate or invest in mutual funds, bonds, or stocks, you must keep in mind the length of time you’ve held security long enough for your assets to qualify for long-term capital gains.

The IRS imposes a 0% to 20% preferential tax rate on properties that qualify for long-term capital gains. In contrast, if you only have a short-term security hold on your property, you will likely pay a higher income tax rate that can go as high as 37%.

Another proven strategy that will help you reduce your taxable income using capital gains involves spreading out capital gains tax payments over an extended period.

Remember, the higher your capital gains, the more likely you are to be moved to a higher tax bracket and end up paying more taxes. As such, spreading your capital gains over two or more years will regulate cash flow and ensure you earn just enough to remain in a lower-income tax bracket.

#4. Taking Advantage of Tax Credits

Tax credits are a convenient way to minimize your tax liabilities, provided that you qualify for them. For instance, if you are a parent with a qualifying dependent, you may be eligible for the Child Tax Credit (CTC).

The CTC lets you claim up to $2,000 for every qualifying child. Other types of tax credits worth looking into include the Earned Income Tax Credit (EITC), which offers tax breaks to taxpayers in low to moderate-income households.

If you earn less than $63,398 or generate investment income that’s worth $11,000 or less, you may be qualified to reduce your taxes and possibly get a tax refund using the EITC.

Meanwhile, the mortgage interest credit lets you claim annual credits for a percentage of the mortgage interest you have paid for your property.

#5. Maximizing Deductions

Some of the most common types of tax deductions that you can maximize include health savings account contributions, medical expenses, and interest on college education costs.

Small business owners can maximize discounted tax rates on business-related expenses such as business interest and bank fees, employee salaries, benefits, and startup costs.

If you’re an independent contractor, you can deduct home office costs, internet and phone expenses, and self-employment taxes from your tax balance.

#6. Charitable Donations

When using charitable donations to reduce your taxes, use Schedule A of Form 1040 to itemize all your donations and maximize your tax savings. You can deduct up to 60% of your adjusted gross income (AGI) if you make cash contributions to public charities.

However, the percentage you can deduct may also be limited or reduced depending on the type of contributions you give to qualifying beneficiaries.

For instance, if you donate goods or services such as clothing and household items, the value of the goods must exceed the fair market value (FMV) to qualify for a deduction.

You can also establish a donor-advised fund, make a single large donation to the said fund, and have the contribution distributed over a number of years. Doing so lets you claim up to 30% of your AGI.

5 Easy Steps to Get Started With Tax Planning

The secret to getting started with tax planning is to follow a series of simple yet feasible steps to strategize your tax management process.

Below is a five-step tax planning strategy that you can easily follow so you can draft a plan in no time:

#1. Evaluate Your Financial Situation

The first thing you need to do is take a closer look at your current finances. Are you dealing with a lot of debt, or do you want to maximize your earnings and increase your savings?

Understanding how your current circumstances, money-wise, can affect your tax planning process in the long run enables you to identify spending habits and investments that may or may not work for your goals.

That said, if you want to reduce your taxes, it would be advisable to check out which tax write-offs or credits are applicable to your source of income and average net earnings.

Or, if you’re in the middle of paying off tax debt from the previous tax years, you must prioritize resolving your tax liabilities while setting aside a percentage of your salary or wages to guarantee that you can pay your succeeding taxes on time.

#2. Understand Tax Law and Regulation

Tax planning is not designed to help you evade your tax responsibilities. It is simply a way for you to figure out how to get more tax advantages based on your filing status, average earnings, and eligibility for certain deductions.

Staying updated with any changes to existing IRS regulations and learning about specific tax rules in your state or locale keeps you from violating any rules and unwittingly incurring penalties.

#3. Set Goals

If there is a tax planning strategy for businesses, then there is also a personal tax planning strategy that’s more tailored to your specific objectives. That said, having one or more clear goals helps you have a more elaborate tax planning strategy.

Let’s say your goals are to reduce your taxes and save more money for educational and housing costs. Then, you can start by listing all applicable solutions to reduce your taxes and implement the said solutions when you file your taxes later on.

Next, focus on budgeting the remaining percentage of your income after paying taxes. If you qualify for the Child Tax Credit or the American Opportunity Tax Credit, then you can set aside the maximum credits you can claim to pay off student debts or build a college fund.

#4. Get Professional Help

Seeking tax planning advice from certified accountants and tax professionals will help you have a clearer and more objective view of your tax planning process.

They can explain in full detail how to prepare a tax planning tactic based on available and applicable investments, tax benefits, and budgeting strategies.

#5. Keep Your Records Organized

File your tax and income records per quarter or label them with the correct date and year. Keep bank statements and purchase receipts in a secure folder that you can use when claiming certain deductions.

If possible, store both printed and electronic copies of your financial records to avoid misplacing your documents.

Better yet, use online tools such as Paystub.org’s 1099 form generator or W-2 form generator to record your gross and net earnings, calculate your taxes, and file your returns in a timely manner.

3 Pro Tips For Efficient and Successful Tax Planning

To ensure you can implement a tax planning method that best suits your finances and objectives, here are additional tips to ponder:

• Don’t procrastinate. Focus on the little things that you can do now, such as creating a rough draft of your tax plan. Start with simple yet practical habits that become consistent over time, and don’t allow yourself to find excuses for delaying your tax planning process.

• Don’t ignore state and local taxes. Some tax rules and deductions may vary by state. You can visit your local tax office or agency if you need more information on existing tax regulations in your area.

• Consider trying an income tax projection. Income tax projection means using your current earnings and expenses as a basis for assessing or estimating the taxes you will potentially owe for the year. Doing so helps you calculate your tax liabilities and budget with more precision.

Final Thoughts

Tax planning benefits all taxpayers, regardless of whether you are being taxed as an individual or as a business owner. It is an efficient way of monitoring your regular expenses and maintaining full compliance with your tax responsibilities.

That said, take your time finding a strategy or tip that suits your goals out of all the tax planning examples described in this article. You can also check out our blog for more helpful guides on how to manage your tax obligations seamlessly.