Tax Planning for Beginners: 6 Key Principles Explained

Tax planning is, by definition, an assessment of your financial situation from a tax perspective for the purposes of reducing how much money you owe the government. Legally, of course. The goal is to take stock of the money you’ve made, and choose which financial choices will promote the most favorable tax treatment. You do this through proper planning, which includes strategizing, timing, leveraging tax advantageous vehicles (i.e., retirement plans), and more.

Tax planning is your roadmap to a lower tax liability. A little bit of planning now can help you save big later. Let's review a few basic principles for the benefit of both individuals and small business owners.

1. Estimating Your Total Income

The first step in tax planning is determining how much money you have or expect to have earned for the calendar year. For anyone who works for a company as an employee, your primary source will be the W-2 that your employer will send you by January 31st. You may also have various 1099s for miscellaneous income as seen below.

• 1099 - MISC: miscellaneous income, most likely earned as a contractor
• 1099 - DIV: dividend income
• 1099 - G: government payouts, i.e. state refunds from prior years
• 1099 - INT: interest income
• 1099 - R: from retirement plans
• 1099 - SA: from HSAs and other medical plans

And that’s just a sample of the 1099s out there!

2. Time Your Financial Transactions

The simplest tax planning strategy to reduce your tax liability is this: defer revenue, accelerate expenses. What in the world does that mean? It’s most useful for businesses who have a high volume of revenue and expense transactions, but it holds true for individuals, as well. There are a few different ways to defer revenue, your income, and accelerate your expenses.

• Increase your retirement plan contributions (401(k), 403(b), traditional IRA)
• Participate in a deferred compensation plan (typically for highly compensated employees)
• Move up expenses (medical, charitable, etc)
• Save for your child’s college education with a 529 plan

While maximizing retirement benefits might seem like a bonus reserved for individual filers, business owners can get in on the action. If you have some extra revenue, consider setting up a 401(k) in your business for yourself or your employees. There numerous other plans for small business like SEPs and SIMPLE IRAs, among others.

Businesses are allowed to claim a tax credit to help cover the cost of setting up and managing a 401(k), and better yet, the business can match plan participant contributions, which is deductible as a business expense. For a 401(k) you can contribute up to $18,500 as a participant and $55,000 for combined employee/employer contributions (for those below the age of 50).

Another way to avoid income tax on your hard earned money? Once you’ve paid tax on that money and you’ve got it on hand, put it to use. Consider purchasing tax-free or tax-deferred securities like:

• Municipal bonds
• US savings bonds
• Roth IRA contributions

You have two deduction choices from the outset: standard deduction or itemized deduction. You may only choose one each year. With the changes of the Tax Cuts and Jobs Act of 2017 voted on December 22, 2017 and effective for the 2018 tax year, this particular area has changed significantly.

• The standard deduction is a set dollar amount that you reduce your taxable income by.
• Itemized deductions allow you to claim specific expenses on your taxes that may be used to reduce your taxable income with caveats.

Historically, the majority of American citizens have opted for the easy option—the standard deduction. And they should, as they save more money this way. Itemized deductions are fickle and typically reserved for the more wealthy citizens among us. The new tax laws have also raised the bar for not taking the standard deduction by almost doubling the deductions up to $12,000/$24,000 for individuals/married couples, respectively (from $6,350/$12,700).

If you pay a lot in property tax, SALT (state and local tax), medical bills, or charitable contributions, it may be worth considering the itemized deduction. The limitations on the property and SALT in 2018 make it more difficult to hit the threshold for taking the itemized deduction, but a qualified tax professional can help you determine what makes the most sense.

4. Retain Your Documents

As noted above, as a small business owner you will find a need for financial statements filing your tax return. Whether you’re filing a Schedule C or a business tax return, it’s important to retain all of your financial records. These include invoices, bills, deposit slips, receipts, contracts, purchase orders, bills of sale, and any other documents related to a transaction of money, goods, or services.

For the individual filer and business owners, it’s vital to also retain copies of your prior year tax returns for at least three years after filing. This is generally the statute of limitations for the IRS to audit your return or for you to amend your return.

Aside from the important tax implications of retaining financial documents, the information on those records—when organized correctly—can provide insight to help you plan for your future. Most professional tax preparers will be happy to look at your old returns to help you plan for future events

5. Understand Tax Credits

Tax credits are another government-sponsored form of tax assistance. Unlike deductions (which reduce your taxable income), credits lower your tax liability dollar for dollar. This makes them a superior savings option for reducing your tax burden—assuming you qualify!

Individuals can take advantage of several tax credits, and a few examples are below:

• Child tax credit: Up to $2,000 from $1,000 in 2017

• Earned Income Credit: Available for low income earners

• Adoption Credit: Following the adoption of a child

• Education Credits: Several are available

Business owners should keep an eye out for the following credits:

• Family Leave Act tax credit for businesses that offer qualifying employees at least two weeks of paid leave each year in addition to other paid time off
• Disabled persons access tax credit for businesses that modify their brick-and-mortar locations to accommodate persons with mobility disabilities
• Research and development tax credit for businesses that perform certain types of research on product development or business performance
• Green initiative tax credit for businesses that upgrade their facilities with energy-efficient technology

These are only a few of the tax credits available. And while not every business will qualify for these incentives, you might be surprised at what exceptions your accountant can find, so keep them in mind during your tax planning preparation.

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6. Work With a Professional

It’s difficult to navigate your taxes on your own, which is why most financial experts recommend that business owners get help with preparing for tax season from an outsourced service provider. Even individual filers who have complex investments, contributions, or deductions should consider getting expert help.

This is a key principle of tax planning because unfortunately, the average American doesn’t have the know-how they need to effectively sort through tax law. There’s a lot to learn, and accountants spend years working it out. While you can certainly try to file on your own, the best way to guarantee that you receive all the tax breaks you’re owed is to have someone walk you through the steps.

Reducing future taxes, saving for retirement, making a large purchase, buying/selling, or running a business while maintaining financial and accounting records can all set you up for success.

Are you ready for tax season? Learn more about what Botkeeper can do for you and your business!