What Is Tax Planning?

What Is Tax Planning?

Let me explain tax planning directly: it's about analyzing your finances to make sure you're paying the lowest taxes possible. If your plan cuts down on taxes, it's tax-efficient. As an individual investor, you need to make tax planning a core part of your overall financial strategy. Reducing your tax liability and boosting contributions to retirement plans are key to your success.

Key Takeaways

You should know that tax planning coordinates various financial strategies to cut down on tax liabilities. It involves timing your income, purchases, and expenditures to get the best financial results. Contributions to retirement plans like IRAs and 401(k)s can significantly drop your taxable income. Using tax gain-loss harvesting offsets capital gains with losses, reducing your tax burden. Finally, grasping long-term capital gains tax brackets helps with strategic planning.

Key Components of Tax Planning

Tax planning covers several areas you need to consider. This includes the timing of your income, the size and timing of purchases, and planning for other expenditures. Your investment choices and retirement plans must align with your tax status and available deductions to achieve the best outcomes.

Tax-Advantaged Retirement Saving Options

One popular way to reduce taxes efficiently is by saving through a retirement plan. When you contribute to a traditional IRA, it lowers your gross income by that amount. For 2023, if you're under 50, you can put in up to $6,500; if 50 or older, add $1,000 more. In 2024, that rises to $7,000, with the catch-up still at $1,000.

Take someone earning $75,000 who contributes $7,000 to a traditional IRA in 2024—their adjusted gross income becomes $68,000, and that's what gets taxed. The $7,000 grows tax-deferred until you withdraw it.

There are other retirement plans you can use to cut tax liability. 401(k) plans are common in larger companies with many employees. You defer paycheck income directly into the plan, and the contribution limits are higher than IRAs.

In 2023, the 401(k) limit is $22,500, going up to $23,000 in 2024. If you're 50 or over, add $7,500 in both years.

Using the earlier example, a $23,000 contribution in 2024 drops the $75,000 income to $52,000 for taxing. That $23,000 grows tax-deferred until withdrawal.

Comparing Tax Planning and Tax Gain-Loss Harvesting

Tax gain-loss harvesting is a specific type of tax planning for investments. It uses your portfolio's losses to offset capital gains. Per the IRS, short- and long-term losses first offset gains of the same type—long-term losses handle long-term gains before short-term, and short-term gains (from assets held under a year) are taxed at ordinary rates.

For 2023, long-term capital gains rates are: 0% for single filers up to $44,625 (or $89,250 joint, $59,750 head of household, $44,625 separate); 15% from $44,626 to $492,300 (or $553,850 joint, $523,050 head of household, $276,900 separate); 20% above that.

In 2024, these increase: 0% up to $47,025 (or $94,050 joint, $63,000 head of household, $47,025 separate); 15% from $47,026 to $518,900 (or $583,750 joint, $551,350 head of household, $291,850 separate); 20% above.

For instance, if you're a single filer with $100,000 income and $10,000 long-term gains, you'd owe $1,500 in tax. But selling investments with $10,000 long-term losses offsets it to zero tax. If you buy back the same investment, wait at least 30 days to avoid a wash sale.

The IRS says if losses exceed gains, you can claim up to $3,000 ($1,500 if married separate) to lower income, or your total net loss if smaller. For someone earning $75,000 with $5,000 net losses, income adjusts to $72,000, with $2,000 carried over indefinitely.

What Are Basic Tax Planning Strategies?

Some basic strategies include lowering your overall income through retirement contributions, claiming tax deductions, and using tax credits.

How Do High-Income Earners Reduce Taxes?

High-income earners, and really all earners, can reduce taxes by contributing to retirement accounts and health savings accounts (HSAs), investing in stocks with qualified dividends, buying municipal bonds, and choosing states with favorable tax treatments.

Can I Contribute to a 401(k), a Traditional IRA, and a Roth IRA?

Yes, you can contribute to all three: a 401(k), traditional IRA, and Roth IRA. Just stick to the annual limits. If you do both traditional and Roth IRAs, your total contributions can't exceed the overall IRA maximum.

The Bottom Line

Effective tax planning reduces your liability using strategies that fit your financial goals, like retirement contributions to IRAs and 401(k)s, timing income and expenses, and gain-loss harvesting. Remember, tools such as tax-efficient retirement saving, deductions, and credits are vital for tax efficiency and long-term success.