Tax planning is important because it helps you take advantage of government tax incentives to reduce your tax liability. Taxes determine the amount of money that you can spend on your needs after paying off the government. Proper tax planning can help reduce your liability and build the right assets for you when you retire.
Nature of Taxes
There are two main types of taxes that most people pay, three if you consider indirect taxation as well; Income tax, wealth tax, and sales tax.
First, there is the income tax that is charged on your annual earnings. Both businesses and salaried individuals are required to pay income taxes. For individuals, the tax is deducted by the employer and submitted to the IRS. The person is still required to submit a tax return that accounts for all their earned income and paid taxes. Businesses must also pay income tax after deducting their taxes for the year.
Wealth tax is charged on the estate a deceased person before their wealth can be passed on to their progeny. The average wealth tax rate is 40%. This means if you have an estate worth $1 million and pass away, the government can take up to $400,000 in taxes before your wealth can be distributed to your children and spouse.
Sales tax is charged on the value of goods or services produced by a business and ultimately paid by the final consumer of the product. To keep this guide streamlined, we won’t go over sales tax reduction strategies.
Should You Plan Your Taxes
Everyone should have some knowledge about taxes and create a plan on minimizing tax liability. It doesn’t matter how much you earn or the amount of wealth you have, a thorough tax plan will help you reduce taxes and keep as much of your income with you as possible, legally.
Tax plans are great for small business owners, sole proprietors. Salaried employees can also get tax benefits from tax planning. People who have built a lot of wealth also need to plan for estate taxes to ensure that as much of their taxes pass to their children and partner as possible.
The main goal of tax planning is to use tax deductions and tax credits to reduce tax expense while focusing on earning sources that are not liable to taxation.
Tax Reduction Is Legal
There is a common misconception that trying to reduce your tax liability is illegal. That is not true. The US government, like most parts of the world, incentivizes certain behaviors through tax breaks because it makes governance easy.
For example, if you save and invest your money into long-term, income-producing assets, you won’t become financially dependent on the government for vouchers or social programs in your old age. If you buy private healthcare insurance, the government won’t have to provide medical care for you. If you invest in education, you will become a productive citizen who can generate income for yourself and the government. Spending your income on any of these will give you tax credits that can be used to reduce tax liabilities.
Tax evasion or deliberately hiding your taxable income is certainly illegal. But using smart strategies for avoiding taxes is NOT. With that maxim in mind, we present five effective strategies for reducing your tax liability.
Max Out Your 401(k), 403(b), IRA or Other Retirement Plans
When you make pre-tax contributions to your employer’s retirement plan, this amount can be used to reduce your total taxable income for the year. This is a great way for salaried persons to reduce tax liability.
You should always try to max out your IRS contribution limit for each period. Employees with 401(k), 403(b), most 457 plans, or the Thrift Savings Plan from the Federal Government can contribute up to $19,000 for 2019. This contribution will directly reduce your taxable income for the period. Workers aged over 50 can also contribute an additional $6,000 for these defined contribution plans to catch up.
Optimize Business Structure
If you are running your own business, you can optimize the structure to reduce your tax liability significantly. Business corporations are taxed differently at a fixed rate. The current tax rate is 21 percent, which has been significantly reduced from the previous rate of 35 percent. If you have been running the business as a sole proprietorship, it may be beneficial to register as an S Corporation to avail the lower tax rate and reduce your tax liability
Review Inventory and Bad Debts at Year-End
Businesses often fail to account for their inventories accurately at the end of the year. Products that have become damaged or obsolete are no longer in ideal selling condition and should be removed from inventory. Eliminating damaged or obsolete products is an allowed deduction for tax calculation.
Your debtor accounts should also be reviewed. There will be some customer accounts that are unlikely to clear their bills. Once you are certain that you won’t be able to recover from them, write them off as bad debts. This will reduce your taxable income as well.
Investment, Education and Travel Expenses
Tax laws allow you to get income tax deductions for any money spent on deriving that income. Whether you are a sole proprietor, stock investor, or registered business, make sure to keep receipts of all your expenses and make them part of your tax return.
These include expenses on continuing education, business travel, lodging, and entertainment. If you own and operate a car for the business, calculate and deduct its cost of operations.
Donate to Approved Charities
Any donations made to registered charities can be used to reduce your taxable income. You can set up donor-advised funds easily at a financial institution or with the help of your tax planning advisor to keep your taxes low.
Summary
It is financially smart and important to try and reduce your tax liability. If you are not actively managing your taxes, you could be paying more taxes than necessary, so start planning your taxes today.