What is tax planning?

Tax planning is a broad term used to describe the processes used by individuals and businesses to pay taxes owed to local, state, and federal tax agencies. The process includes elements such as managing tax implications, understanding what types of expenses are deductible under current regulations, and generally planning taxes in a way that ensures the amount of taxes owed is paid in a timely manner.

One of the main approaches to tax planning is to apply prevailing tax laws to income received during a given tax period. Revenue may come from any revenue generating mechanism that is currently in operation for the entity in question. For individuals, this can mean sources of income such as interest earned on bank accounts, wages, salaries and tips, bonuses, investment earnings and other sources of income as currently defined by law. Companies will consider income generated from sales to customers, issuances of stocks and bonds, interest-bearing bank accounts and any other source of income currently deemed taxable by the appropriate tax authorities.

In many cases, the main objective of tax planning is to apply the laws in force in order to allow the individual or legal entity to reduce the amount of taxable income for the period. So tax planning involves knowing what types of income currently qualify as tax-exempt. The process also involves understanding what types of expenses can legitimately be considered deductions and what circumstances must exist for the deduction to be claimed on the tax return.

There are three common approaches to tax planning to minimize the tax burden. The first is to reduce adjusted gross profit for the fiscal period. This is where understanding current tax laws when it comes to subsidies and exemptions comes into play.

A second approach to tax planning is to increase the amount of tax deductions. Again, this means knowing the current laws and applying them where appropriate for all normal and customary expenses associated with the home or business. As these may change from one year to the next, it is always a good idea to check current regulations.

A final approach that may be applicable to effective tax planning has to do with the use of tax credits. This can include credits related to retirement savings plans, college expenses, child adoption, and various other credits. A common example of a tax credit is the Accumulated Income Credit, which aims to alleviate the tax burden of people earning less than a certain amount in a given calendar year.