While the term “tax planning” is frequently used, it is not necessarily well understood. Here’s what you need to know.
What tax planning really means
Tax planning is the art of arranging your affairs in ways that postpone or avoid taxes. By employing effective tax planning strategies, you can have more money to save and invest or more money to spend. Or both. Your choice.
Put another way, tax planning means deferring and flat out avoiding taxes by taking advantage of beneficial tax-law provisions, increasing and accelerating tax deductions and tax credits, and generally making maximum use of all applicable breaks available under our beloved Internal Revenue Code.
While the federal income tax rules are now more complicated than ever, the benefits of good tax planning are arguably more valuable than ever before.
Of course, you should not change your financial behavior solely to avoid taxes. Truly effective tax planning strategies are those that permit you to do what you want while reducing tax bills along the way.
How are tax planning and financial planning connected?
Financial planning is the art of implementing strategies that help you reach your financial goals, be they short-term or long-term. That sounds pretty simple. However, if the actual execution was simple, there would be a lot more rich folks.
Tax planning and financial planning are closely linked, because taxes are such a large expense item as you go through life. If you become really successful, taxes will probably be your single biggest expense over the long haul. So planning to reduce taxes is a critically important piece of the overall financial planning process.
Over the years we have been amazed at how many people fail to get the message about tax planning until they commit a grievous blunder that costs them a bundle in otherwise avoidable taxes. Then they finally get it. The trick is to make sure you don’t have to learn a lesson, the hard way, that you cannot ignore taxes. If you do, bad tax results can and will happen.
The last word
There are many other ways to commit expensive tax blunders. Like selling appreciated securities too soon when hanging on for just a little longer would have resulted in lower-taxed long-term capital gains instead of higher-taxed short-term gains; taking retirement account withdrawals before age 59½ and getting hit with the 10% premature withdrawal penalty tax; or failing to arrange for payments to an ex-spouse to qualify as deductible alimony; the list goes on and on.
The cure is to plan transactions with taxes in mind and avoid making impulsive moves. Seek professional tax advice before pulling the trigger on significant transactions. The wealth you may potentially save is, after all, yours.