The goal of tax planning is to maximize after-tax wealth.

When done properly, the goal of tax planning is not to minimize your taxes. Instead, the goal is to maximize the money that is left after taxes.

That may sound like a trivial distinction — like I’m just playing games with words here. But it makes a real difference in the analysis.

Let’s look at two common examples, starting with the more obvious one.

Mortgage Interest

You have a $300,000 mortgage with a 3% interest rate. You itemize your deductions every year, and you are able to fully deduct the interest you pay on your mortgage. You have a 25% marginal tax rate, when both federal and state income taxes are considered.

You have $50,000 in a checking account, which you don’t really need for “emergency fund” purposes. Let’s imagine that it’s from a CD that just matured.

If you use that $50,000 to pay down your mortgage, you’ll be saving yourself $1,500 of interest per year. You will lose a $1,500 deduction, which means that your taxes will go up by $375, given a 25% tax rate. But your overall financial position is still improved by $1,125 per year.

Your taxes went up, but that’s fine. The goal is not to minimize taxes, but rather to maximize the amount of money left after taxes. Prepaying your mortgage achieves that goal, in this case.

Let’s move to our second, less obvious example.

Roth vs Tax-Deferred

Looking at your budget for this year, you determine that you have sufficient cash flow to make $7,500 of Roth contributions to your 401(k) this year. Alternatively, you could make tax-deferred (“traditional”) contributions. You currently have a 25% marginal tax rate, and you expect to have a 15% marginal tax rate in retirement. You also expect that, given the length of time in question, this money will approximately triple in value between now and the time you take it out of the account.

If you make Roth contributions, there is no effect on your income tax this year (because the contribution is not deductible), and when you take the money out in retirement, it will be completely tax-free.

Alternatively, if you have $7,500 of available cash flow this year, you could contribute $10,000 to a tax-deferred 401(k), given a 25% marginal tax rate. (That is, if you make tax-deferred contributions of $10,000, you’ll have tax savings this year of $2,500, so your cash flow this year will only be affected to the tune of $7,500, which is the amount we have decided you can afford.)

If you make tax-deferred contributions, when you take the money out (by which point the $10,000 will have tripled in value to $30,000), you will have to pay a total tax of $4,500, given your anticipated 15% marginal tax rate in retirement.

So, in our example, with tax-deferred contributions, you end up paying more tax in total. You get $2,500 of savings up-front, but you pay $4,500 of additional tax later. If you do the analysis with the goal of minimizing taxes, you would make Roth contributions.

But which option actually leaves you with more after-tax money?

In the Roth case, you contribute $7,500, and that money triples to $22,500. And $22,500 is already the after-tax value, because it can come out of the account tax-free.

In the tax-deferred case, you contribute $10,000, and that money triples to $30,000. But then you have to pay $4,500 of taxes. Still, your after-tax value is $25,500 (i.e., $3,000 more spendable dollars than you would have if you had made Roth contributions).

Overall point being, when you contribute to Roth accounts rather than tax-deferred accounts, you generally pay a smaller dollar amount of income tax (because you’re paying tax now, on the amount of the contribution, rather than on the larger amount of the distribution after it has grown over time), but that doesn’t necessarily make it better. Because the goal isn’t to minimize taxes. The goal is to maximize the after-tax dollars that you have available to you.

Focus on After-Tax Dollars

This topic comes up with so many of the common tax planning questions. Which account(s) should I spend from this year? Which assets should I hold in which accounts (i.e., asset location)? Should I spend down my traditional IRA in order to delay Social Security? Should I make a donation from my taxable assets, or via a qualified charitable distribution?

In each case, calculating the taxes paid under Option A and calculating the taxes paid under Option B — then comparing those two amounts — is such an obvious, intuitive way to do the analysis. And in each case, that method can lead you to poor decisions.

"Very easy to read and is a perfect introduction for learning how to do your own taxes. Mike Piper does an excellent job of demystifying complex tax sections and he presents them in an enjoyable and easy to understand way. Highly recommended!"

Tax planning refers to the analysis of a financial situation with the purpose of reducing tax liability. The tax plan ensures that all elements of the financial plan work together to minimize tax contributions. Through tax planning, individuals ensure they can attain maximum tax capability. Reducing tax liability increases the ability to make contributions to retirement plans and add additional savings which are vital for financial and retirement success. Tax planning consists of various considerations such as taxable income, filing status, adjustments and exemptions, tax deductions and tax credits, and lastly major purchases and investments. Tax planning is crucial for businesses and individuals to help achieve financial goals and objectives.

The main objectives of tax planning

The main objective of tax planning is to reduce one’s tax liability. Authorities, like the IRS, implement legal measures and regulations to ensure citizens pay the required tax amount. Effective tax planning helps individuals and businesses save more money while adhering to legal and regulatory requirements. Tax planning is the foundation of effective financial planning. It ensures that savings from taxes are generated according to the legal obligations required by the government. Business owners ensure that finances saved from taxable sources are redirected towards income-generating plans. Tax planning also ensures that businesses take appropriate precautions to avoid future litigation or audits.

Importance of tax planning

Tax planning plays a key role in outpacing the cost of living and inflation while maximizing returns. When assessing investment value, inflation, expenses, and tax are all taken into account. The tax burden on properties can have huge impacts on one’s overall portfolio With investments, individuals should ensure the portfolio is well-diversified and designed to suit their needs and goals. Without effective tax planning, returns are likely to be diminished by taxes.

Reduced tax bills

Paying low taxes reduces the expenses incurred by an individual or a business when paying expenses. Working towards tax efficiency is the best way to hold together assets and capital. Capital gains tax and income tax can both be reduced with effective tax planning. Reviewing one’s tax plan can reduce the impact tax expenses may have on one’s financial situation.

Flexibility in tax payment

Proper tax planning provides individuals and businesses with a more flexible approach to paying taxes. Flexibility in tax payment reduces the impact on personal or company finances allowing individuals and businesses to gain full control of their finances. As a result, preventing the pressure of paying more taxes than income. Gaining control of all payment arrangements makes it easier to budget one’s finances and achieve sustainability.

Advantages of tax planning

To get a head start

For businesses operating under a trust, tax planning can create an estimate of trust distribution, saving the need to make rash decisions. Businesses are able to look at the available options and strategize according to analyzed data. Starting tax planning earlier allows the business to attempt more strategies to maximize tax savings.

To minimize litigation

Tax evasion and avoidance can occur due to high taxes. Tax planning helps in resolving possible tax disputes with federal, state, and local authorities. This can save individuals and business entities from legal liabilities.

To see the bigger picture

Tax planning allows individuals and businesses to get an insight into their current financial situation. Individuals can assess whether the business structure needs a change and get a sense of potential profits and revenue from alternative opportunities. If a change is needed to be made, tax planning can help determine the best course of action.

To ensure economic stability

Effective tax planning provides a healthy flow of money that contributes to economic progress. Individual and business tax planning creates more money available for personal use and prevents the risk of bankruptcy that may result from difficulties in bills and loan payments. A stable economy benefits both the citizens and the country.

Types of tax planning

Purposive tax planning

Purposive Tax planning involves using tax-saving instruments with the specific purpose of getting the maximum tax benefit by making correct investment selections, suitable replacements of assets, and diversifying income and business activities.

Short-range tax planning

Tax planning is conducted and implemented at the end of the fiscal year. Individuals and entities looking to invest resort to short-range tax planning and search for ways to limit tax liability at the end of every financial year. Although this method does not involve long-term commitments, it promotes substantial savings.

Long-range tax planning

Under this method, the planning is conducted at the beginning of the year, and taxpayers follow the plan until the end of the year. This type of planning does not offer immediate tax benefits, but it is beneficial in the long run.

How can Arrowroot Family Office help you with your tax planning?

Arrowroot Family Office was created to bring a solution to the complex financial and investment lives of many families. Arrowroot Family Office helps in tax planning by incorporating the asset class features during portfolio optimization. Arrowroot Family identifies the most effective approach to a client’s portfolio according to each individual portfolio and profile.. Arrowroot Family seeks to eliminate these differences when evaluating after-tax returns to ensure effective tax planning. Arrowroot Family Office prioritizes equity allocation to achieve tax efficiency. The organization favors tax-efficient techniques by maintaining minimal tracking error and improving on losses. Therefore, Arrowroot Family Office specializes in helping clients meet their financial goals and retain as much income as possible through effective tax planning.

Helping you achieve your evolving financial objectives

Frequently asked questions

Are our tax planning strategies illegal?

Tax planning is a legal and ethical method of keeping taxes at the minimum level. However, strategies applied in tax panning can be termed illegal if they do not adhere to legislation. The strategies should be based on legislation and judicial rulings on tax exemptions, debate, relief, and deductions.

Are tax planning fees deductible?

Tax planning fees on the year of payment are considered miscellaneous itemized deductions and cannot be deducted from the taxpayer. The tax planning fees include the cost of electronic filing of returns, tax publications, and software programs for tax planning.

Is tax planning legal?

The law allows taxpayers to arrange their finances in a cost-effective way to reduce tax obligations. Tax planning is legal because it involves organizing financial conduct in an efficient way.

Is tax planning effective?

High taxes can affect the annual income leading to financial instability. To avoid this, tax planning is considered the most effective way of reducing tax liabilities. Tax planning is effective because it uses benefits and exemptions provided by the law to minimize tax bills.

What are tax planning strategies?

Tax planning strategies refer to the ways in which individuals and businesses use to defer current tax liability to the future, thereby freeing up more funds for personal use or investment. Tax planning strategies are centered on increasing income, reducing deductions, and lower tax rates.

How is tax planning different from tax evasion?

Tax evasion is the deliberate act of an individual or entity to avoid paying taxes, while tax planning is the financial analysis to ensure a person or an entity pays the lowest taxes possible. The main difference between tax evasion and tax planning is legality. While tax planning is allowed by the law, tax evasion is completely illegal.

How much does tax planning cost?

The average cost of tax planning by hiring a professional tax ranges between $146 and $457. However, it can be cheaper if a person decides to purchase the accounting software and perform the panning for themselves.

Who needs tax planning?

Individuals and business owners need tax planning to reduce tax liability and increase savings and productivity.

Who does tax planning?

Tax planning is provided by CPA specialists and accounting firms with experience in tax law and finance. The CPA specialist of accounting firms should ensure that the tax reporting and planning complies with the state and national tax law. However, individual taxpayers can use attorneys, agents, and tax preparers for personal tax planning.

Why is tax planning necessary?

Tax planning is necessary to build personal finances and save more cash for investment. It also helps to minimize the income tax payable every financial year, thereby boosting the savings available during retirement. Proper tax planning helps businesses achieve their financial goals by maximizing deductions and gaining greater control of taxes.

What is the goal of tax planning?

What is tax planning and its features?

What is tax planning meaning?