What Is Tax Planning And How It Works
What Is Tax Planning?
Tax planning is when you analyze your financial situation or plan to make sure everything is working together to help you pay the least amount of taxes. It's about finding ways to be tax efficient, meaning you're reducing how much you have to pay in taxes. Tax planning is important for individual investors because it helps them lower their tax bills and make the most of retirement plans. By doing this, you increase your chances of financial success.
Key Takeaways:
Tax planning means looking at your financial situation or plan to make sure everything is set up to help you pay the least amount of taxes.
When you do tax planning, you think about things like when you get your income, how much money you make, when you buy things, and how you plan your expenses.
Some tax planning strategies include saving money for retirement in an IRA or doing something called tax gain-loss harvesting.
Understanding Tax Planning
Tax planning involves thinking about different things. Some of these things include when you get your income, how much money you have, when you buy things, and planning for other expenses. It's also important to choose the right investments and retirement plans that match your tax situation and deductions. By doing all this, you can make sure you get the best possible outcome when it comes to taxes
Retirement Saving Strategies
Saving money for retirement through a retirement plan is a popular way to lower your taxes effectively. By contributing money to a traditional IRA, you can reduce your total income by the amount you contribute. In 2022, if you're under 50 years old and meet all the requirements, you can contribute a maximum of $6,000 to your IRA. If you're 50 years old or older, you can contribute an extra $1,000. In 2023, the contribution limit goes up to $6,500, but the catch-up contribution remains at $1,000.
Let's take an example to understand better. Imagine a 52-year-old man earning $50,000 per year. If he contributes $7,000 to a traditional IRA, his adjusted gross income would become $43,000. The $7,000 contribution would then grow without taxes until he retires.
Apart from traditional IRAs, there are other retirement plans available to help reduce your tax liability. One popular option is a 401(k) plan, commonly offered by larger companies with many employees. Participants can defer a portion of their income directly into the company's 401(k) plan. The contribution limits for a 401(k) are much higher compared to an IRA.
Using the same example as before, the 52-year-old could contribute up to $27,000 to their 401(k) in 2022 (increasing to $30,000 in 2023). If someone is under 50 years old, they can contribute up to $20,500 ($22,500 for 2023), but if they're 50 years old or older, they can contribute up to $27,000 ($30,000 for 2022) due to the allowed additional catch-up contribution of $6,500.
In 2023, the catch-up contribution limit for 401(k) plans rises to $7,500.
Tax Gain-Loss Harvesting vs. Tax Planning
Tax gain-loss harvesting is another way to manage your taxes when it comes to your investments. It's useful because it allows you to use any losses in your investment portfolio to offset any gains you may have. According to the IRS, when you have capital losses, both short-term and long-term, they must be used first to offset the same type of capital gains. This means that long-term losses are used to offset long-term gains before they offset any short-term gains. Short-term gains are the earnings from assets that you've owned for less than a year, and they are taxed at regular income rates.
As of 2022, the tax rates for long-term capital gains are as follows:
0% for single filers with income up to $41,675 ($83,350 for joint returns or widows/widowers, $55,800 for individuals who are head of household, or $41,675 for married individuals filing separately)
15% for single filers with income between $41,676 and $459,750 ($517,200 for joint returns or widows/widowers, $488,500 for individuals who are head of household, or $258,600 for married individuals filing separately)
20% for those with income higher than the limits mentioned for the 15% tax rate
In 2023, the income limits for long-term capital gains will increase as follows:
0% for single filers with income up to $44,625 ($89,250 for joint returns or widows/widowers, $59,750 for individuals who are head of household, or $44,625 for married individuals filing separately)
15% for single filers with income between $44,626 and $492,300 ($553,850 for joint returns or widows/widowers, $523,050 for individuals who are head of household, or $276,900 for married individuals filing separately)
20% for those with income higher than the limits mentioned for the 15% tax rate
Let's understand this with an example. If a single investor has an income of $100,000 and earns $10,000 in long-term capital gains, they would have a tax liability of $1,500. However, if the same investor sells underperforming investments and incurs $10,000 in long-term capital losses, those losses would offset the gains, resulting in no tax liability. If the same losing investment is repurchased, at least 30 days must pass to avoid a wash sale.
According to the IRS, if your capital losses exceed your capital gains, you can claim the excess loss up to $3,000 ($1,500 if married filing separately) to lower your income. This is the lesser of the two amounts. For example, if the 52-year-old investor had a net capital loss of $3,000 for the year, their $50,000 income would be adjusted to $47,000. The remaining capital losses can be carried forward indefinitely to offset future capital gains.
