What is Tax Planning?
The term “tax planning” refers to the technique used for analyzing the financial situation of an individual to design investment and exemption strategy with the objective of ensuring optimum tax efficiency. A sound tax plan requires all the elements of a financial plan to work in unison in the most tax-efficient way. It is very important for individual investors it can potentially reduce their tax liability and enhance their ability to contribute to their retirement fund for the future.
Every individual is required to pay taxes according to the applicable income tax brackets and so it is essential that they do their tax planning efficiently to achieve their financial goal. An individual can make the best use of the available exemptions and deductions to reduce their tax liability. For instance, some investors opt for joint IT filing along with their spouse in order to enjoy the benefits of lower-income of the other partner. Effective tax planning can cut down tax payments significantly. However, it is important to note that tax planning is different from both tax avoidance and tax evasion, which are not allowed under the tax laws.
Objectives of Tax Planning
As already mentioned above, tax planning is an essential part of an individual investor’s financial planning. It helps in channelizing taxable income to various investment opportunities which results in lower tax liability. In the future, investments can be used to fulfill different financial goals, such as retirement corpus, child education fund, etc. Overall, it can be said that the primary objective of tax planning is the reduction of tax liability.
How does Tax Planning Work?
Tax planning has to take into account several factors, which include periodic income, size and timing of planned expenses, type of investments, and applicable exemptions. For instance, a contribution to a retirement fund is the most common way to reduce tax liability. Anyone below the age of 50 years can reduce their gross income by up to $6,000 by contributing that much amount to a traditional IRA. Lower gross income means lower tax payment. This is how tax planning works.
Examples of Tax Planning
Following examples are given below:
Let us take the example of a married couple to explain the concept of tax planning.Let us assume that one of the partners is a basic rate taxpayer, while the other partner fall in a higher tax bracket. They also have a secondary income source through rental income. Who should be reporting the rental income in their tax filing to ensure efficient tax planning?
In this case, it would be logical that the partner with the lower income (basic rate taxpayer) reports rental income in the tax filing. This would ensure lower combined tax liability for the couple.
Let us take the example of David who is entitled to exemption of income from outside the US. During 2016, he earned $65,000 working outside the US, which he received over a period of 2 years: $35,000 in 2016 and $30,000 in 2017. David has the option to either report the entire income in 2016 on an accrual basis or over the 2-year period on a cash basis. Determine what reporting should be beneficial for him if the exemption limit for any year is $40,000.
In case David reports the entire income in 2016 on an accrual basis, then he will able to avail of tax exemption of up to $40,000 only. However, if he reports them on a cash basis then he can avail of tax exemption of $35,000 in 2016 and $30,000 in 2017, which means a total exemption of $65,000. So, it would be logical for him to do the tax filing on a cash basis.
Types of Tax Planning
Tax planning can be broadly categorized into four major types:
- Purposive Tax Planning: In this type of tax planning the tax provision is done in an intelligent way to avail the tax benefits while following a certain well-defined objective, such as a change in investment strategy, diversification of business activities, etc.
- Permissive Tax Planning: This type of tax planning takes advantage of various exemptions, deductions and concessions while following all the rules permissible under various tax provisions and framework of law. In short, permissive tax planning is done according to the provisions of the tax laws.
- Short-Range Tax Planning: In this type of tax planning temporary tactics are executed at the end of the year to achieve certain specific objectives.
- Long-Range Tax Planning: In this type of tax planning the strategies are formed at the start of the year and their results are only visible in the long run.
Need of Tax Planning
The underlying need for a better standard of living now and in the future drives the need for tax planning. An efficient tax planning can minimize the impact of taxes on the cash inflow and significantly speed up the process of wealth accumulation for the future.
Advantages of Tax Planning
Some of the major advantages of tax planning are as follows:
- It reduces the tax liability by utilizing the benefits of all available deductions.
- It helps in saving more money that can be invested in some other productive investment opportunities to build a stable source of secondary income.
- If executed properly, it can mitigate the risk of unnecessary litigations pertaining to taxation.
Disadvantages of Tax Planning
Some of the major disadvantages of tax planning are as follows:
- Usually, it results in blockage of fund for purchasing tax saving investment products, which can impact liquidity in the short-term.
- At times the taxpayers fail to distinguish between tax planning and tax evasion and so they end up misinterpreting the provisions under the tax law.
So, it can be seen that tax planning is donewell within the applicable limits of the tax laws. There are several tax saving options available that can be evaluated to check whether or not they actually help in tax savings.
This is a guide to Tax Planning. Here we also discuss the introduction and how does tax planning work? along with advantages and disadvantages. You may also have a look at the following articles to learn more –