The Importance of Tax Planning


Tax planning is an activity that may result in substantial tax savings. It is an art of arranging financial affairs and defers taxes through taking advantage of beneficial tax-law provisions, increasing and accelerating tax deductions, and tax credits. Basically, it is maximizing the use of all applicable breaks available under Internal Revenue Code.

Tax is a kind of cost and reduction of cost shall increase the profitability. Every prudence person, to maximize the return, shall increase the profits by resorting to a tool known as tax planning. The basic strategy is to time your income so that it will be taxed at a lower rate and to time your deductible expenses so that they may be claimed in years when you are in a higher tax bracket. For instance, if you expect to be in lower tax bracket in 2018 than in 2017, you should defer the receipt of income to 2018 and accelerate your deductions until 2017. Conversely, if in 2018 it is expected to be in the higher bracket, then you should accelerate your income 2017 and defer deductions in 2018.

Another illustration, Ms. X met Mr. Y, shortly after they decided to get married. Ms. X got too excited and impulsively sells her house before marrying Mr. Y, which she bought 15 years ago. She remodeled the property and appreciated by $500,000. They planned to move to Mr. Y house which is a dump. Without tax planning, Ms. X gained $250,000 from the sale and taxed at an assumed combined federal and state tax rate of 25%. If Ms. X resorted to tax planning, she could have kept her house and live there with Mr. Y for two years before selling. She could have avoided the $250,000 of taxable gain, an exclusion that is available to married joint-filers.

Your most direct control over your tax bracket rests in your ability to control the timing of your income and deductible expenses. However, you should also be aware of more indirect factors that act to change your tax bracket from one year to the next. Among these factors are:

• Filing Status. For the married couple, the filing choices are "married filing jointly" and "married filing separately". A single person generally selects "single" filing status. However, a single person who lives with and provides support for a dependent may file as "head-of-household".

• Income level. The biggest variable determining your marginal tax rate is your income level, so big changes in income from this year to the next may open the door to several tax planning opportunities. Marriage and divorce often have a drastic effect on your income level.

• "Preference" items. When you think you have beaten the tax system by maximizing your itemized deductions and/or making the most of other tax breaks, you may find that the alternative minimum tax (AMT) has ruined your plans. The AMT system is in place to ensure that you pay a minimum level of tax. Thus, if your deductions are too high and you've taken advantage of too many other tax breaks, some or all of these "preference" may be disregarded or modified in the AMT calculation.

Methods of Tax Planning

• Short-range Planning. It means that planning thought of and executed at the end of the income year to reduce taxable income in a legal way. Suppose, at the end of the year, an assessee finds his taxes have been too high in comparison with last year and he tends to reduce it. Now, he may do that, to a great extent by making proper arrangements to get the maximum tax rebate. It does not involve a long-term commitment, yet results in substantial savings in tax.

• Long-range Planning. A planning that chalked out at the beginning of the income year to be followed by the year. This planning will not pay off immediately, but likely to help in the long run.

• Permissive tax Planning. This is a planning of taking advantage of different incentives and tax deductions, planning for availing different tax concessions.

• Purposive Tax Planning. It means making plans with a specific purpose to ensure availability of maximum benefits to the assessee through correct selection of investments, making a suitable programme for replacement of assets, varying residential status and diversifying business activities and income.

In making use of all beneficial provisions and relaxations provided in the tax law must be availed by legitimate means. Tax savings must conform to the legal obligations and requirements.