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Updated December 29, 2023 Reviewed by Reviewed by Thomas BrockThomas J. Brock is a CFA and CPA with more than 20 years of experience in various areas including investing, insurance portfolio management, finance and accounting, personal investment and financial planning advice, and development of educational materials about life insurance and annuities.
Fact checked by Fact checked by Hans Daniel JaspersonHans Daniel Jasperson has over a decade of experience in public policy research, with an emphasis on workforce development, education, and economic justice. His research has been shared with members of the U.S. Congress, federal agencies, and policymakers in several states.
Tax planning is the analysis of a financial situation or plan to ensure that all elements work together to allow you to pay the lowest taxes possible. A plan that minimizes how much you pay in taxes is referred to as tax efficient. Tax planning should be an essential part of an individual investor's financial plan. Reduction of tax liability and maximizing the ability to contribute to retirement plans are crucial for success.
Tax planning covers several considerations. Considerations include timing of income, size, and timing of purchases, and planning for other expenditures. Also, the selection of investments and types of retirement plans must complement the tax filing status and deductions to create the best possible outcome.
Saving via a retirement plan is a popular way to efficiently reduce taxes. Contributing money to a traditional IRA can minimize gross income by the amount contributed. For 2023, if meeting all qualifications, a filer under age 50 can contribute a maximum of $6,500 to their IRA with an additional catch-up contribution of $1,000 if age 50 or older. That number rises to $7,000 in 2024, with the catch-up contribution holding steady at $1,000.
If an individual who made $75,000 a year contributed a total of $7,000 to a traditional IRA in 2024, they would have an adjusted gross income of $68,000 ($75,000-$7,000) on which they would be taxed. The $7,000 would then grow tax-deferred until withdrawn.
There are several other retirement plans that an individual may use to help reduce tax liability. 401(k) plans are popular with larger companies that have many employees. Participants in the plan can defer income from their paycheck directly into the company’s 401(k) plan. The greatest difference is that the contribution limit dollar amount is much higher than that of an IRA.
In 2023, the contribution limit for a 401(k) is $22,500, increasing to $23,000 in 2024. For both years, if you are 50 and over, you can contribute an additional $7,500.
If we take the example above, if an individual contributed $23,000 in 2024, their adjusted gross income would be $52,000 ($75,000-$23,000) on which they would be taxed. The $23,000 would grow tax-deferred until withdrawn.
Tax gain-loss harvesting is another form of tax planning or management relating to investments. It is helpful because it can use a portfolio's losses to offset overall capital gains. According to the IRS, short and long-term capital losses must first be used to offset capital gains of the same type.
In other words, long-term losses offset long-term gains before offsetting short-term gains. Short-term capital gains, or earnings from assets owned for less than one year, are taxed at ordinary income rates.
In 2023, long-term capital gain limits are the following:
In 2024, long-term capital gain limits will be increasing to the following:
For example, if a single investor whose income was $100,000 had $10,000 in long-term capital gains, there would be a tax liability of $1,500. If the same investor sold underperforming investments carrying $10,000 in long-term capital losses, the losses would offset the gains, resulting in a tax liability of 0. If the same losing investment were brought back, then a minimum of 30 days would have to pass to avoid incurring a wash sale.
According to the Internal Revenue Service, "If your capital losses exceed your capital gains, the amount of the excess loss that you can claim to lower your income is the lesser of $3,000 ($1,500 if married filing separately) or your total net loss shown on line 16 of Schedule D (Form 1040)."
For example, if an individual earned $75,000 a year and had $5,000 in net capital losses for the year, the $75,000 income will be adjusted to $72,000 ($72,000-$3,000). The remaining $2,000 in capital losses can be carried over with no expiration to offset future capital gains.
Some of the most basic tax planning strategies include reducing your overall income, such as by contributing to retirement plans, making tax deductions, and taking advantage of tax credits.
There are many ways to reduce taxes that are not only available to high-income earners but to all earners. These include contributing to retirement accounts, contributing to health savings accounts (HSAs), investing in stocks with qualified dividends, buying muni bonds, and planning where you live based on favorable tax treatments of a specific state.
Yes, you can contribute to a 401(k), a traditional IRA, and a Roth IRA. You must ensure that you only contribute the legally allowed amount per year. If you invest in both a traditional IRA and a Roth IRA, you cannot contribute more than the overall maximum allowed for an IRA.
Tax planning involves utilizing strategies that lower the taxes that you need to pay. There are many legal ways in which to do this, such as utilizing retirement plans, holding on to investments for more than a year, and offsetting capital gains with capital losses.
