Why Tax Planning is so Important

Do what you want, but do it in a tax-smart way

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, ta planning means deferring and flat out avoiding taxes by taking advantage of beneficial tax-law provisions, increasing and accelerating tax deductions and generally making maximum use of all applicable breaks available under our beloved internal Revenue Code.

Also read: You may owe the IRS $10,000

While the federal income tax rules are now more complicated than ever, the benefits of goods 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 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 probable 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.

Horror stories when folks fail to make the connection

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Over the years as a tax pro, I have been amazed at how many people fail to get the massage 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 this lesson the hard way. To
illustrate the point, consider the following example.

Example Josephine us a 45 year old unmarried professional person. She considers herself to be financially astute. However, she is not well-versed on taxes. One day, Josephine meets Joe, and they quickly decide to get married. Caught up in the excitement of a whole new life, Josephine impulsively sells her home shortly
before the marriage. The property is in a great area and has appreciated by $500,000 since she bought it 15 years ago. She intends to move into Joe’s home, which is a dump, but Josephine is a proven genius at remodeling, and she plans to work her usual magic on Joe’s property.

Result without tax planning For federal income tax purposes, Josephine has a whopping $250,000 gain in the sale of her home ($500,000 profit minus the $250,000 home sale gain exclusion allowed to unmarried sellers).

Result with tax planning: If Josephine had instead kept her home and lived there with Joe for two years before selling, she could have taken advantage of the larger $500,000 home sale gain exclusion available to married joint-filers and thereby permanently avoided $250,000 of taxable gain. If necessary, Joe’s home
could have been sold instead of Josephine’s. Alternatively, Joe’s property could have been retained and the couple could have worked on remodeling it while still living in Josephine’s home for the requisite two years.

Moral of the story? By selling her home without considering the tax-smart alternative, Josephine cost herself $62,500 in taxes (completely avoidable $250,000 gain taxed at an assumed combined federal and state rate of 25%). This is a permanent difference, not just a timing difference. The point is, You cannot ignore
taxes. If you do, bad things can happen, even with a seemingly intelligent transaction.

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