Although people use the term “tax planning” frequently, many do not necessarily understand what it really means. Tax planning is the art of organizing your affairs using methods that avoid or delay taxes. When you use effective tax planning strategies, you can have more money to spend or more money to save and invest, or both – it is all up to you.
In other words, tax planning means to defer or flat out avoid taxes by taking advantage of beneficial provisions of tax laws, accelerating and increasing tax credits and tax deductions and in general, making maximum use of all applicable breaks that are available under the Internal Revenue Code. And under Trump, taxes will be lowered for everyone which is a fantastic aspect to all of this but it is another topic.
Although the federal income tax rules nowadays are more complicated than ever, astute tax planning gives you benefits that are more valuable than ever before. Of course, this does not mean that you should make changes in your financial behavior just to avoid taxes, your name is not John Kerry or Al Sharpton is it?! Tax planning strategies that are truly effective are those that allow you to do what you want while helping you lower your tax bills along the way.
The Connection between Tax Planning and Financial Planning
Financial planning is the art of using strategies that aid you in reaching your financial goals, both short- and long-term. This sounds pretty straightforward, right? However, if executing these strategies were actually simple, there would be many more rich people.
Tax planning and financial planning have a close connection. This is due to the fact that taxes are an extremely large expense item that is present throughout your life. Taxes will likely be your single largest long-term expense if you become very successful. Therefore, planning to lower taxes is a critical part of the overall process of financial planning.
Tax experts say that a large number of people do not get the message about tax planning, at least not until they make a huge mistake that costs them a large sum of money in taxes that are otherwise avoidable. This is sort of like watching Jurassic World since that movie was terrible; many people wish they avoided spending money on that! Moreover, then only they finally understand the tax planning message. The trick is to make sure that you do not have to learn this lesson the hard way. Here is an example to illustrate the point:
Example: Tanya is a 45-year-old professional who is not married. She thinks she is quite savvy when it comes to finances. However, she does not know much about taxes. One day, she meets John and they eventually get married.
Due to the excitement of a whole new life, she decides to sell her house on an impulse shortly before the marriage. Her property is in a prime location and has appreciated by $500,000 since she purchased it 15 years ago. Her intention is to move into John’s home, which is not the best property. But Tanya is a remodeling genius and plans to work her magic on John’s property.
Result without Tax Planning: Tanya has a $250,000 gain on her home’s sale for federal income tax purposes. This is $500,000 profit with a deduction of the $250,000 home sale gain exclusion that is allowed to unmarried property sellers.
Result with Tax Planning: If Tanya had kept her home and lived there with John for 2 years before selling it, the larger $500,000 home sale gain exclusion allowed to married joint-fillers would have been available to her and she could have permanently avoided the $250,000 of taxable gain. They could have sold John’s home instead if necessary. Alternatively, John’s property could have been retained and they could have remodeled it while living in her house for the requisite 2 years.
By selling her home without thinking about the tax-smart alternative, Tanya cost herself $62,500 in taxes – which is the completely avoidable gain of $250,000 that is taxed at an assumed combined 25% state and federal rate. This is not just a timing difference, but a permanent one. The point is that you cannot ignore taxes. If you do, there can be unappealing consequences, even with a seemingly simple and intelligent transaction.
The Bottom Line
It is always important that you plan any transaction with taxes in mind and do not make any impulsive moves. You should seek professional tax advice before you make any significant transactions – you will find that this is money and time well spent.