Significance of tax planning

Tax planning will often result in substantial tax savings. If you use a calendar year for preparing and filing your tax return, your opportunity for tax planning will end on December 31. Therefore, with some exceptions, when you do prepare your tax return two to three months after the end of the year, it is generally too late to do anything.

Tax planning involves the timing and method by which your income is reported and your deductions and credits are claimed. In general, you should defer income into a subsequent year and accelerate deductions into the current year. You also need to consider if the income can be taxed when you are in a year with a lower marginal tax rate (marginal tax rate = highest rate that is applied in the tax computation for a particular taxpayer) and the deductions claimed in a year when you are at a higher marginal tax rate. For example, if you expect to be at a lower marginal rate , you should defer the receipt of income and accelerate deductions.

Three cardinal rules for tax planning:

  • Defer tax whenever possible
  • Recognize income when your marginal rate is low
  • Pay deductible expenses when your marginal rate is high

Planning around your marginal tax rate

Controlling your marginal rate of tax rests in your ability to time your income and deductible expenses. Some other factors that may change your marginal rate of tax from year to year follow.

Filing status

There are four schedules of tax rates that apply to individuals. Two apply to married persons and two to single persons. For married persons, the choices are “married filing jointly” and “married filing separately.” On occasion, a married couple may be able to reduce their overall tax liability by filing separate returns. If separate returns are filed, each spouse reports his or her income and deductions on separate returns. Moreover, for tax purposes, your marital status is determined on the last day of the year.

Single people generally select “single” filing status. If a single person lives with and provides support for a dependent he or she may file as “head-of-household.” These rates are more favorable than the rates that apply for “single” status.

Income level

Your level of income will determine your marginal tax rate. Therefore, significant changes in income from year to year may present planning opportunities. A marriage or divorce can have a major impact on your level of income, as do job changes, retirement, inheritances, illness, and sale of investments.

Tax preference and adjustment items

So called “preference items” and “adjustment items” (some examples include: certain tax exempt interest income, incentive stock options, and certain itemized deductions) are relevant with regard to the Alternative Minimum Tax (AMT). The AMT is in place to make sure that you pay at least a minimum level of tax. Consequently, if your deductions are significant and/or you have taken advantage of too many other tax opportunities, some or all of the “preference items” and “adjustment items” may be disallowed or adjusted for purposes of the AMT calculation. The important thing for you to know at this time is that if you have significant deductions or preference/adjustment items, you may be subject to the AMT. If you are subject to this tax, you may be at a higher marginal rate than you anticipate. Because of this possibility, planning for the AMT is very important.

Conclusion

Tax planning is now much more than just deferring income and accelerating deductible expenses towards year-end. Major Tax Acts over recent years guaranteed lower tax liabilities for almost everyone. But with so many changes being phased in and out over the next several years, you will need a scorecard to keep it straight. Also, with many more options now available, tax-planning strategies should be considered year-round and not only towards year-end.