What Is Tax Planning All About?

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What Is Tax Planning All About?

Tax planning involves taking a pro-active approach to paying taxes. While it is illegal to avoid paying taxes that you owe, there is nothing wrong with looking at your income and potential deductions in advance so as to pay the least amount of tax possible under the law. There are a number of steps you can take to reduce your tax obligations, many of which involve saving for retirement, childcare, and medical expenses.

Why plan?

Income taxes on the federal level are a fact of life, and many people also have to pay state and local taxes. When you make an effort to plan around taxes, you can save yourself money that you would otherwise pay to the federal, state or local governments. While you may not notice the impact of federal taxes, they are the biggest expense that most families incur in the course of a year.

For example, if you save for retirement, whether in the form of an employer-based program such as a traditional 401(k) or individual retirement account (IRA) or both, you can save money on taxes. You don’t get a current tax deduction for contributions to a Roth 401(k) or Roth IRA, however. Saving in a traditional 401(k) or traditional IRA reduces your taxable income when you make a contribution, but distributions are taxed; while a Roth 401(k) and Roth IRA offers no deduction for contributions, but qualified distributions (including earnings) are not taxed.

Major tax planning

There are many areas of your financial life that can benefit from tax planning. Here are some of the ones that can pay off in the biggest ways:

• Retirement contributions: Contributing to a retirement plan is one of the best ways you can save for your own future and save money on taxes. When you contribute to a traditional 401(k) plan at work, those contributions reduce your taxable income, so you will owe less tax at the end of the year. When you contribute to a traditional IRA, you also reduce your taxable income, as you will record how much you contributed on your tax form, and that may reduce your income.
• Flexible spending account contributions: Contributions made to medical expense flexible spending accounts and dependent care flexible spending accounts are made through employers who offer them. These contributions are made on a pre-tax basis, so you save money on healthcare or dependent care-related expenses. Be aware that you must use all or most of your flexible spending account contribution in the year it was contributed or within a few months of year’s end; otherwise, you will lose those balances.
• Health savings account contributions: If you have a high-deductible health plan, you can deduct the contributions that you make. This has an additional benefit of not only saving you money on your taxes, but also helping you save for healthcare expenses and pay for those on a pre-tax basis.
• Charitable donations: If you donate money to a church, social services organization or non-profit, and you itemize your deductions, you can save money if your itemized deductions exceed your standard deduction. It’s important to document what you donate by obtaining a receipt from the charitable organization.