Tax Planning: What It Is, How It Works, and Best Strategies

There’s more to tax planning than keeping track of your important tax documents—although that is a great start. Proper tax planning utilizes the current tax law to maximize your tax deductions and credits and minimize your tax liability.

Used effectively, it can be an important part of your financial management strategy and help you meet your short- and long-term financial goals. Tax planning—as a component of comprehensive financial planning—is important for both individuals and businesses.

What are the key components of tax planning?

Deducting, deferring, dividing, disguising, and dodging are key components. These are also known as the five pillars of tax planning. By implementing these tax-saving strategies, you can minimize your tax liability and preserve more of your income for your financial goals.

Deducting

You should be taking full advantage of all deductions and credits available to you. As an individual taxpayer, maximizing your deductions may mean either taking the standard deduction or itemizing your deductions. You should also be aware of tax credits that may be available to you based on your lifestyle and spending habits. Tax laws change frequently, and you may be eligible to claim tax credits for expenses you have incurred—such as education or energy savings.

Deferring

Timing your income and expenses appropriately is a key component of tax planning. As a rule of thumb, you want to delay paying tax until the last possible moment. Due to the time value of money, an expense in the future is cheaper than an expense right now. Similarly, income now is more valuable than income in the future.

Dividing

You may be able to legally shift money to other family members who pay taxes in a lower tax bracket. This tax-planning strategy is referred to as income splitting.

Disguising

Disguising involves converting money from one type of income to another that is taxed at a lower rate. For example, for every new dollar of income you bring in, ordinary income is taxed at your marginal tax rate while most capital gains are taxed at a maximum of 20% in 2023.

Dodging

This does not refer to tax evasion: the illegal hiding of income which results in an underpayment of required taxes. Dodging refers to tax avoidance—arranging your finances to pay the lowest possible taxes while adhering to the current tax laws.

Tax-planning strategies for individuals

As an individual taxpayer, you should maximize your deductions and be aware of various tax credits you can take based on your lifestyle and expenses. As much as possible, make tax-efficient investments and set yourself up for a tax-friendly retirement. If you have the ability to transfer money to another family member in a lower tax bracket, you can also take advantage of income splitting.

Standard deduction vs. itemized deductions

It is important to understand the difference between standard and itemized deductions. Depending on your financial situation, you may benefit from itemizing your tax deductions.

What is the standard tax deduction?

The standard deduction is a specific amount that the Internal Revenue Service (IRS) allows you to deduct from your income before calculating your tax liability. The amount changes annually, and the IRS releases its inflation adjustments on its website prior to the relevant tax year.

For tax year 2023, the standard deduction is:

• $13,850 for single filers and married individuals filing separately.
• $20,800 for heads of households.
• $27,700 for married couples filing jointly.

What are itemized deductions?

Itemized deductions are specific amounts you have paid for certain allowable expense categories throughout the tax year. If the sum of all your expenses exceeds the standard deduction for the tax year, you should itemize your deductions. The following expenses may be included in itemized deductions:

• State and local income or sales taxes (SALT).
• Real property taxes.
• Personal property taxes.
• Mortgage interest.
• Disaster losses.
• Charitable contributions.
• Medical and dental expenses (limited to the extent expenses exceed 7.5% of your AGI in 2023).

Read this article for seven common write-offs you can deduct from your taxes.

The significance of tax credits

Unlike deductions, tax credits directly reduce the amount you owe on your tax bill. For example, a $2,000 tax credit will take your $10,000 tax liability down to $8,000. This makes tax credits even more valuable than tax deductions on a per-dollar basis. Some of the most significant tax credits relate to your children or other dependents and education expenses.

Tax credits for children and other dependents

Here are some child-related tax credits you may qualify for:

• Adoption credit for adoption costs.
• Child and dependent care credit for daycare or nanny costs.
• Child tax credit for claiming a qualifying dependent under the age of 17.
• Credit for other dependents who do not qualify for the child tax credit.

Tax credits for education

Here are some education-related tax credits:

• American Opportunity Tax Credit (AOTC) for eligible education expenses in the first four years of higher education.
• Lifetime learnings credit (LLC) for expenses paid to an eligible educational institution—not limited to the first four years of higher education.

Other valuable tax credits

Other tax credits include those for low-income earners, retirement savings, and energy savings, such as:

• Earned Income Tax Credit (EITC) for workers whose earned income is lower than a threshold determined by the IRS based on filing status and number of dependents.
• Clean vehicle tax credit for the purchase of qualifying electric vehicles.
• Energy efficiency tax credits for the purchase of items that make your home more energy-efficient.

Education savings

A 529 plan, or qualified tuition program, is a tax-advantaged education savings account. While you cannot deduct contributions made to a 529 plan, the withdrawals are tax-free if used for qualified educational expenses. You also benefit from the tax-free growth of your invested funds.

Retirement planning

There are several tax-advantaged retirement options to consider. Here are three of the most common.

• 401(k): Offered by your employer, this tax-deferred account allows you to deduct your contributions in the current tax year. You will be taxed on your withdrawals in retirement.
• Traditional IRA: This tax-deferred account allows you to deduct contributions in the current tax year if you meet certain criteria. You will owe taxes on your withdrawals in retirement.
• Roth IRA: This after-tax retirement account does not allow you to deduct contributions on your taxes, but qualified distributions in retirement are tax-free.

What are tax-advantaged investments?

A tax-advantaged investment is any investment option that offers a tax benefit. It could be tax-deferred (401(k) or traditional IRA), or tax-exempt in the future (Roth IRA). Including tax-advantaged accounts in your portfolio is a good tax planning strategy.

Robinhood offers traditional IRAs and Roth IRAs for individuals who are looking to save for retirement outside of their employer. You can easily fund your retirement account by setting up an automatic transfer to your Robinhood account. It’s a great option for investors who want to have control over their retirement account.

Which states don’t tax retirement income?

Moving to a state that is tax-friendly for retired individuals is a great retirement-planning strategy. For example, the following eight states do not tax retirement income:

• Alaska.
• Florida.
• Nevada.
• South Dakota.
• Tennessee.
• Texas.
• Washington.
• Wyoming.

Other states may have special provisions that limit the tax you will pay on your Social Security or pension income. Read this article for more information on states that don’t tax retirement income.

Tax-planning strategies for businesses

Here are a few common tax-planning strategies for your small business.

Take advantage of the qualified business income (QBI) deduction

The QBI deduction allows owners of pass-through businesses to deduct up to 20% of their share of the business’s income. If you qualify, this is a great benefit for a small business owner.

Pass-through businesses are those where the owner pays taxes on their share of the business’s income on their personal tax return—such as a sole proprietorship or partnership. C corporations do not qualify for the QBI deduction.

Defer or accelerate income and expenses

As a small business owner, you likely use the cash method of accounting. With cash accounting, you recognize revenue when cash is received and expenses when cash is paid. This allows for some flexibility in how you time your revenue and expenses around year-end.

If you expect to be in a higher tax bracket next year, you can defer paying an expense until January to reduce your future net income. If you expect to be in a lower tax bracket next year, you may want to delay sending an invoice to your clients until January to keep your current year’s net income lower. Tax laws are constantly changing, and tax rates for pass-through business owners may change considerably in certain years. Your tax professional can help you identify these opportunities.

Planning capital gains and losses

As we mentioned earlier, it’s always a good idea to defer paying taxes as long as possible. You may be able to defer capital gains tax by reinvesting the funds from your sale in another way. Here are two methods:

• Reinvest funds into a Qualified Opportunity Fund within 180 days of realizing the gain.
• Make a like-kind exchange—in which you reinvest in real property used for business or investment purposes after selling and realizing a gain on real property used for the same purpose.

Set up or contribute to your retirement

Eligible small businesses may qualify for a tax credit of up to $5,000 for the set-up expenses incurred in starting a SEP, SIMPLE IRA, or 401(k). Your business may qualify if you had the following:

• 100 or fewer employees who made over $5,000.
• At least one plan participant who was a non-highly compensated employee.
• No other employer-sponsored plan in the prior three years before the start of this plan.

Additionally, you can deduct your own contributions to your 401(k) after setting up the plan.

Tax-planning strategies for investors

A tax-efficient investment strategy allows your investments to grow more quickly thanks to the extra funds retained from your tax savings. Of course, always diversify your investment portfolio to minimize your risk in the long term. But for the current tax year, you may be able to utilize loss harvesting to minimize your tax bill.

Diversify your portfolio

Diversifying your investment portfolio reduces your long-term risk due to market fluctuations and changing tax laws by allocating your funds across various investment types. For instance, you can hold some retirement funds in a tax-deferred account, where you will pay taxes in retirement, and some in a tax-exempt account, where you pay taxes now but not when you withdraw. Similarly, you may want to blend higher-risk investments with some low-risk, more stable investments. Yieldstreet offers an array of available investments - from real estate and art to diversified funds to both accredited and non-accredited investors with a potential for substantial returns. Learn more on our review.

Harvest investment losses

You can harvest your investment losses by selling your devalued investments at a loss to reduce the tax you owe on capital gains you realized in the same tax year. When you sell an investment at a loss, it creates a realized loss. The realized loss can be applied against your gains to reduce your overall taxable gain. This is a strategy which can be identified and incorporated by a financial advisor such as J.P. Morgan.

TIME Stamp: Effective tax planning can reduce your tax liability and preserve your hard-earned income

By having an effective tax plan, you can reduce your tax bill and save toward your financial goals. Tax planning is a significant part of overall financial planning, and you should consider the tax implications of all your personal, investing, and business decisions. Since every situation is different, it’s prudent to discuss your plans with a tax professional before you make major financial decisions.

As an individual taxpayer, you should know which tax deductions and credits you qualify for. As a business owner, you should time your revenue and expenses to minimize your tax bill in the tax year that you’re subject to a higher tax rate. Pass-through business owners can take advantage of the QBI deduction. Lastly, funding a retirement account is a great way to save money on your tax bill. Just make sure but make sure your investments are well diversified and follow a tax-efficient investing strategy.

Frequently asked questions (FAQs)

What are the five pillars of tax planning?

The five pillars of tax planning are: deducting, deferring, dividing, disguising, and dodging.

How do high-income earners reduce taxes?

High-income earners can reduce their taxes through effective financial planning. This may involve the help of multiple financial professionals, such as a Certified Public Accountant (CPA), to address the tax-planning portion of their overall financial plan and a financial advisor for their investment and retirement strategies.

If you’d like access to a network of financial professionals, consider opening an account with Empower. Its team of professionals can help you set up a customized financial strategy.

If you want the benefit of an optimized financial plan without incurring the expense of multiple financial professionals, you can use an app like Playbook. Playbook is a tax-efficient investing system that helps high-income earners identify opportunities to minimize their taxes while optimizing their investments.

What happens to your tax liability with proper financial planning?

With proper financial planning, you can minimize your tax bill and preserve more of your income.