CuVantis Education Series

What is Tax Planning and Why is it Important?

In practice, tax planning is simply examining your financial situation to implement strategies that reduce or minimize your tax burden. When it comes to accumulating wealth, it is often said, “It’s not what you make, but what you keep, that’s important.”  Since taxes can potentially consume up to 1/3 or more of what you make, proper tax planning allows you to keep more of what you earn.

What does it mean for an investment to be Tax Deductible?

Every year when you file your income taxes, you are required to report all of your earned income (salary, wages, self-employed income, etc.) as well as your unearned income (interest or dividends on savings and investments, etc.)  The total of these items, minus certain deductions, becomes the income on which you are required to pay taxes.   A tax-deductible investment into an IRA, 401k or other qualified account decreases the amount of income on which you are required to pay taxes.  For example, if you have earned income of $50,000 and contribute $5,000 to a tax-deductible account, you would be required to pay taxes on only $45,000. If you were in the 15% tax bracket, that deduction would save you $750 in taxes ($5,000 x 15%).

What does it mean to be Tax-Deferred?

Once that $5,000 is invested into an IRA, 401k or other tax-deferred account, you hope that it will begin to grow through interest, dividends or capital gains.  Tax-deferred simply means that the earnings the investment generates are not required to be claimed as taxable income in the year received, but rather are deferred until you actually withdraw the money.  Continuing our example from above, if your $5,000 investment earned 4% interest ($200) in any given year, that $200 would not be required to be claimed as unearned income in the current year saving you an additional $30 in taxes ($200 x 15%). While tax-deductible refers to the principal amount of your investment, tax-deferred refers to the earnings your principal generates.

What is a tax credit?

A tax credit is a direct offset of your tax liability.  If for example, the tax bill from your $45,000 worth of taxable income was $6,750 (15%) but you also had a $1,000 tax credit, that credit would be used to reduce your tax liability down to $5,750.

What is an Estate Tax?

An estate tax is a tax due on assets transferred to heirs at a person’s death if the value of the estate exceeds certain amounts.  In 2020, the “exclusion limit” is $11,580,000. Through the “unlimited marital deduction” spouses can leave any amount to one another without triggering the estate tax, but when the surviving spouse dies, the beneficiaries may then owe estate taxes if the estate exceeds the exclusion limit.  Because the estate tax can be as high as 40%, the use of trusts, gifting or other strategies can be very important to ensuring a family’s wealth stays intact.

As you can see, proper tax planning to manage your tax liability can result in significant tax savings. Use our Estate Tax Calculator to estimate your estate tax or our Roth IRA vs Traditional IRA Calculator to see which, if either, might be right for you.  To find out more please complete the form below to request an appointment with one of our advisors.

The information presented here is for educational purposes only and should not be considered financial, tax or investment advice. Please consult a qualified professional.

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