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Tax Planning

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Tax PlanningPaying taxes has become one of the most convoluted procedures that we suffer through in this great country (even worse than going to the DMV!).  Taxes have become the single biggest annual expenditure for many people.  They affect pretty much every area of our personal finances.  Tax planning can help reduce this burden.

I firmly believe we should be honest in all of our dealings, including taxes.  However, I also firmly believe that we have no obligation to pay one cent more in taxes than what we are legally required by law.  A US Federal judge once said:

“Anyone may arrange his affairs so that his taxes shall be as low as possible; he is not bound to choose that pattern which best pays the treasury.  There is not even a patriotic duty to increase one’s taxes.”  Judge Learned Hand

As a CPA and financial planning professional, I use tax planning on a daily basis to help people minimize their tax liability as much as legally and ethically possible so that they can do what they want with their money rather than fund the White House Halloween decorations.

After all, the less tax you pay, the more money you have for other worthwhile goals such as:

Role of Tax Planning in Personal Finances

Tax planning plays a crucial part in any personal financial plan.  Lack of tax planning can result in a large percentage of a person’s wealth being forfeited to the government.

The purpose of tax planning is to orchestrate your financial affairs in a way that furthers your life and financial goals while also minimizing your tax liability.  Here are a few examples:

  • A 25 year old with a low marginal tax rate and little wealth should probably not have his entire investment portfolio invested in municipal bonds, even if it reduces his taxes.
  • Taking out a home equity loan to pay off credit card debt may reduce your tax liability, but could be an awful personal finance move in certain situations.

Tax planning is great, but it must be filtered through the lenses of life and your overall financial plan.

Income Tax Planning Strategies

There are numerous tax planning techniques to minimize income taxes, but many of them boil down to a few general strategies, which are listed below.  I also list a few examples of each, which are intended to be comprehensive by any means.

1.  Defer recognizing income and paying taxes to the future

  • Postpone the sale of appreciated investments
  • Use a tax advantaged retirement savings vehicle, such as a Traditional IRA
  • Delay retirement distributions
  • Instalment sales
  • Exchange of like-kind assets

2.  Maximize deductions

  • Purchase a home rather than rent to take advantage of home-related deductions
  • Bunch and shift deductions to maximize benefits
  • Convert non-deductible personal interest (i.e. credit card interest) to deductible home equity loan interest
  • Use a Flexible Spending Account

3.  Accelerate Deductions

  • Sell investments that have decreased in value
  • Prepay real estate taxes and state and local income taxes
  • Accelerate charitable contributions

4.  Reduce taxable income

  • Invest in municipal bonds

5.  Earn income taxed at a preferential or lower rate

  • Use tax efficient investment strategies
  • Transfer income producing assets to family members in a lower tax bracket

6.  Eliminate future taxes

  • Save for future education expenses using a 529 plan
  • Invest in a Roth IRA
  • Invest in a Health Savings Account
  • Contribute certain long term capital gain property to charity

7.  Take advantage of tax credits

  • Child tax credit
  • Education credits
  • Adoption credit

These tax planning strategies are not always appropriate.  In fact, in certain situations, they may be the exact opposite of what you should do, which is why it is so important to consult a tax professional.  For example:

  • If you are in “AMT,” the best course of action may be to accelerate income and delay certain deductions.
  • Transferring too much income producing assets to children could potentially incur kiddie tax or be an unwise estate planning move.
  • You might defer income or accelerate deductions but if your marginal tax rate increases significantly the following year that could be very counterproductive.

Seek Professional Help

Many people want to do some smart tax planning in order to reduce their tax burden but feel overwhelmed by the complexity of our tax system.  They don’t know where to start.

It may be advisable to seek out the help of a tax professional, such as a CPA, who can review your tax situation and help you come up with a plan to reduce your taxes.  I would especially recommend seeking advice if your tax situation is complicated.

Software makes it easy for many people to prepare their own tax returns, but it is tough to beat the tax planning and advice that a tax professional can provide.

Tax Software

Tax software makes it very easy and affordable for most people to prepare their own returns, as long as their taxes are not overly complicated.

The software asks you questions, and then prepares your return depending on the answers you provide.  It holds your hand through the process and generally makes it quick and easy, even for people who know nothing about taxes.

I’ve been using TurboTax to prepare my own return for years and would recommend it to anyone.  However, there are many other providers of tax preparation software as well.  I list below some of the other ones I’m familiar with:

Records Management System

It is important to keep good tax records.  You should keep copies of your tax returns and supporting documentation for at least 3 years.  Some tax documents should be kept longer, or even indefinitely.  This will help greatly if your tax return is audited down the road or if a third party requires it, such as for a mortgage.  Having a good recordkeeping system is highly encouraged.

Additional Tax Planning Information

For additional information on taxes, you might read the following books:

What are your thoughts on tax planning?  What (legal) tax planning strategies do you use to reduce your tax liability?  What tax preparation software do you use and what has your experience been?  Leave a comment below!

Image: JaggedPixels/bigstock


{ 1 comment… add one }

  • Keri November 4, 2012, 7:11 pm

    The fact that a CPA recommends Turbo Tax speaks volume to me. I’ll have to give it a try. I couldn’t agree with Judge Hand more. I currently use a CPA to prepare my return but don’t get any tax planning advice. I like your thought that it may be better to prepare my own return but to use a CPA for some tax planning. Seems like it’s not in a CPA’s best interest to say that, so I appreciate your honesty.


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