Tax planning is analyzing an individual’s current financial situation or financial plan to ensure that all of the components work together and that they are legally paying the lowest possible amount in taxes. Tax planning is a crucial part of an individual’s financial plan, as minimizing the amount one pays for taxes and maximizing the amount of money one can put into one's retirement plan is crucial to long-term financial success.
The key to reducing one’s tax liability is to lower the amount of one’s gross income that is subject to taxes. One of the best tools to achieve this is contributing more of your pretax dollars into your retirement savings like a traditional IRA or a 401(k). Contributing to a traditional IRA or a 401(k) can reduce your taxable income by the amount invested, allowing that invested amount of your annual income to grow tax-deferred until retirement. Though using a traditional IRA reduces your taxable income in the same way as a 401(k), investing in a 401(k) offers the additional advantage that the contribution limit dollar amount is much more significant; therefore, you can put more money away to grow tax-deferred and lower your adjusted gross income by a greater amount.
KEY TAKEAWAYS
- Tax planning analyzes an individual’s financial situation to help them pay the lowest possible taxes.
- Tax planning is crucial to long-term financial success.
- Investing in a retirement plan allows you to reduce tax liability.
- A 401(k) offers a greater contribution limit dollar amount than a traditional IRA, allowing more money to grow tax-deferred.
2024 HIGHLIGHTS & UPDATES
- The contribution limit for employees who participate in 401(k), 403(b), and most 457 plans, as well as the federal government's Thrift Savings Plan, increased to $23,000, up from $22,500.
- IRA Contribution Limit: The limit on annual contributions to an IRA increased to $7,000, up from $6,500.
- The catch-up contribution limit for employees aged 50 and over who participate in 401(k), 403(b), and most 457 plans, as well as the federal government's Thrift Savings Plan, remains $7,500 for 2024.
For the most up-to-date information, refer to the official IRS website.
What are Special Considerations When Tax Planning?
Special considerations are financial strategies that can help you save money by reducing your tax liability. As previously mentioned, contributions to retirement plans like a tax-deferred 401(k) or a Roth 401(k) can result in a tax reduction—another consideration when tax planning related to investing is utilizing tax-loss harvesting. Tax-loss harvesting can be used to offset the capital gains tax owed. Since short-term capital gains are taxed at a higher rate than long-term capital gains, investors can sell an asset for a loss to reduce the total amount of capital gains taxes due.
Tax-loss harvesting is only possible with taxable brokerage accounts and cannot be combined with 401(k)s, IRAs, or other tax-deferred accounts. Lastly, taking advantage of tax credits and deductions should also be considered when making a tax plan, as they can reduce tax liability.
What's the Difference Between Tax Credits & Deductions?
Both tax credits and tax deductions reduce the amount of money you will end up paying in taxes, but they do so in different ways, and it is vital to understand how each works. In short, a tax deduction is an expense that you can deduct from your taxable income, reducing the amount you owe. A tax credit, on the other hand, offers a reduction of your tax bill. A tax credit is generally better than a tax deduction. For example, a $10,000 tax credit will save you more than a $10,000 tax deduction. Tax deductions work by deducting your taxable income before your tax bracket’s rate is applied to calculate your bill. This has a lesser effect on lowering your tax bill than a tax credit, which is taken out of your taxes after the bill has already been calculated with your current tax bracket’s rate.
How Does a Tax-Deferred 401(k) Differ From a Roth 401(k)?
Both a tax-deferred 401(k) and a Roth 401(k) offer tax benefits but vary in how they provide those benefits. A tax-deferred 401(k) reduces your taxable income and saves you on taxes today. There are different types of tax-deferred 401(k)s, like a traditional 401(k), a simple 401(k), and a safe harbor 401(k), and they all reduce your tax liability by working in the same way. All tax-deferred 401(k)s set aside their pay before taxes are applied, lowering your taxable income. This money stays tax-deferred until you start withdrawing it post-retirement, at which point you will pay taxes. Contributions to a Roth 401(k) will not reduce your taxable income upfront. Instead, it will reduce the amount you owe as a retiree withdrawing from your Roth 401(k). This is because your contributions to a Roth 401(k) are not taken out of your paycheck before taxes are withheld like in a traditional 401(k). Instead, they are taken out after taxes.
By paying the taxes as you contribute to your Roth 401(k), you will not have to pay taxes on the funds you withdraw. In general, people whose income during retirement will be in a lower tax bracket than when employed opt for a tax-deferred 401(k). People who expect their retirement income to put them in a higher tax bracket opt for a Roth 401(k).
What Are Some Other Ways to Reduce Income Tax Liability?
Apart from contributing money to a retirement plan, the next best way to reduce income tax liability is through tax deductions and tax credits.
One of the most popular forms of tax deduction comes from charitable contributions. Donating money, cars, art, investments, or other things to qualified charitable organizations can all reduce taxable income. Arizona provides two separate tax credits for individuals who make charitable donations, one for donating to Qualified Charitable Organizations and another for donations to Qualifying Foster Care Charitable Organizations. Your donation can reduce dollar-for-dollar what you owe in state income tax up to $400 if you file individually. For more information about how donating can help you save on your taxes or to find qualified charitable organizations, visit https://azdor.gov/tax-credits and https://www.flagstafftaxcredit.org/donate. This is, of course, only one of the many different possibilities when it comes to tax deductions or credits.
“Charitable contributions must be claimed as itemized deductions on Schedule A of IRS Form 1040. The limit on charitable cash contributions is 60% of the taxpayer's adjusted gross income for tax years 2023 and 2024. The IRS allows deductions for cash and non-cash donations based on annual rules and guidelines.”
Some other options include adoption credits for the cost of adopting a child, property tax deduction, and– if you work from home– a portion of the money you spend on mortgages, property taxes, utilities, and similar expenses can be written off as home office expenses. These are just some of the hundreds of deductibles and credits offered that you can take advantage of to lower your tax liability.
Time to Start Planning Your 401(k) Savings
A tax plan that benefits you by leveraging special considerations to save money by reducing your income tax liability is crucial to long-term financial success. By investing your money into a retirement plan, like a traditional IRA, a tax-deferred 401(k), or a Roth 401(k), you can save yourself money on your income taxes by reducing your taxable income by the amount of money invested. In addition to contributing to your retirement accounts, you can leverage many different tax deductions and tax credits to reduce further the amount owed on your taxes.
Creating a tax plan that considers the best ways to maximize the money you save by lowering your taxable income can be time-consuming and difficult. There are many factors to take into consideration when coming up with a tax plan. Decisions like tax deductions and credits you apply for, which types of retirement plans would benefit you the most, and how much money you invest into those savings are very important. Benefit & Financial Strategies, LLC. professionals in Flagstaff can help you assemble the right tax plan.