Income Tax Planning: How to plan your taxes early and minimize your tax outgo
There are two types of taxpayers – those who plan their taxes at the very last minute and are at risk of making certain costly mistakes, and others who start their tax-planning early and are better-positioned to minimise their tax outgo and boost their savings. So, if you’re looking to ensure a smooth tax filing process and save money in tax outgo, you’ll be well-advised to plan your taxes early. Read on as we discuss a few tips on how to go about it.
- Select the right tax-saving instrument
As you start planning your taxes early, i.e. several months before the current financial year ends, you should try to strike the right balance in terms of choice of tax-saving instruments. You should ideally select tax-saving investments that can help you achieve your financial goals in time. Early planning allows you to carefully evaluate the returns offered by your shortlisted investment products and figure out which ones are aligned with your financial goals and risk appetite and can suffice your liquidity requirements.
For example, if you are close to retirement, you might benefit more by investing in tax-saving debt-oriented investment products that carry minimal risk, like Public Provident Fund (PPF), National Savings Certificate (NSC), among others. On the other hand, if you are young and looking for a high return, you should keep certain equity-oriented tax-saving products like Equity Linked Savings Schemes in your investment portfolio.
It will be pertinent to note here that there are various tax-saving tools that come with a lock-in period of 3 years, 5 years, and even longer, and you can choose as per your financial goals and other considerations.
- Invest through instalments
A common misconception is early tax planning is synonymous to investing lump-sums in tax-saving instruments. This is not true. In fact, it’s better to invest through instalments to gain rupee cost averaging benefits while keeping liquidity concerns at bay. As you get closer to the end of the financial year, you can increase or seize the investments depending on whether you have exhausted the tax deduction limit under the prescribed Income Tax Act. For example, under section 80C you can invest in the ELSS, PPF, etc. every month.
You need to keep in mind that you don’t exceed the investment threshold allowed under the applicable act for a tax deduction. For example, the deduction threshold u/s 80 C is Rs 1.5 lakh, and if you invest more than this applicable prescribed limit, you won’t get any additional tax benefit on such excess investment.
- Exhaust the allowances received from the employer
There are several allowances that employers provide to their employees – like food coupons, reimbursements on mobile and internet bills, among others – which can lower your tax liability. By planning early in the financial year, you get sufficient time to utilise these allowances efficiently and reduce the tax outgo. Using tax-saving allowances also helps in alleviating the burden on your financial budget as you can focus on using the fund for other expenses.
- Estimate your tax obligation and avoid last-minute glitches
Make an estimation of your tax liability for the current financial year and use that estimate to determine your monthly or quarterly tax obligation. It will help you to ascertain how much would be your tax liability at the end of the year, and accordingly, you can fine-tune your tax-saving investment steps every month or quarter. If there is a deviation in income in any month or quarter, you can accordingly increase or decrease your tax-saving investments.
Taking last-minute tax-saving steps can also put you at risk of committing serious and irreversible financial mistakes. So, the better option is to always plan it early and remain stress-free.
Important Tax Deadlines
Mark your calendar with these tax filing and retirement account deadlines. Doing so can help simplify your financial life and may help you avoid IRS penalties.
January 31, 2020
- Is the deadline for employers to mail out W-2 Wage and Tax Statements and generally, for businesses to send various Forms 1099, which report non-employee compensation, bank interest, and distributions from a retirement plan, and help calculate your total taxable income. However, extended timelines may apply, resulting in a later mail date.
Feb. 18, 2020
- Is the deadline for businesses to send various Forms 1099 for accounts which include securities and report interest, dividends, capital gains and losses, and other income to help you calculate your total taxable income. However, extended timelines may apply, resulting in a later mail date.
July 15, 2020
- Is the filing and payment date for 2019 federal income tax returns due April 15. You can file electronically or postmark your paper submission by that date.
- The new due date to file an extension to income tax returns is July 15, 2020 (extended from April 15, 2020). The extension only goes to Oct.15, 2020. Payment is still due July 15.
- The new deadline to make your IRA contribution for the 2019 tax year is July 15, 2020.
October 15, 2020
- Individuals who filed for an extension need to file their 2019 federal income tax return by October 15, 2020. Returns filed by mail must be postmarked no later than this date. However, you should estimate and pay any owed taxes by the July 15 deadline to help avoid possible penalties.
- If you are self-employed and filing for an extension for your personal taxes, you will have until the Oct. 15 deadline to file the paperwork for your individual tax return. However, any taxes you owe are still due on July 15.
December 31, 2020
- Is normally the deadline to take required minimum distributions (RMDs) for 2020 tax year, but due to the CARES Act no RMD is required to be taken in 2020.
- December 31 is the last day to convert a Traditional IRA to a Roth IRA for the 2020 tax year.
- The deadline to sell non-qualified securities to realize a gain or loss for the 2020 tax year is December 31, 2020, if appropriate.
- December 31 is the last day to make charitable gifts which may qualify for a federal income tax deduction on your 2020 return.
Timing is Everything
Timing can make a big difference when it comes to your year-end tax bill. When you sell assets or pay your debts can make a big difference.
If you look at the investments in your non-retirement accounts at the end of the year, and see which investments are winners and losers, you might want to decide whether to sell these winning or losing investments. Selling those investments can affect your tax situation for the year. You can use up to $3,000 in short-term losses to offset up to $3,000 of regular income each year. However, you can carry forward unused short-term losses for future use. Figure out which of the investments in your portfolio you want to sell now or later, depending on how it will affect your present and future tax plans.
There are other ways to plan ahead for spending that can help you reduce your tax bill. Charitable contributions can affect your tax bill as well. If your charitable giving doesn’t typically push you above the standard deduction amount, you might want to consider bunching deductions. That essentially means you donate several years’ worth of charitable gifts in a single year, which ends up pushing you above the threshold so you benefit from itemizing your deductions. A tax attorney or another financial professional can help you figure out how to time your giving and how to plan for that.
What Is Income Tax
Income tax is a direct tax that a government levies on the income of its citizens. The Income Tax Act, 1961, mandates that the central government collect this tax. The government can change the income slabs and tax rates every year in its Union Budget.
Income does not only mean money earned in the form of salary. It also includes income from house property, profits from business, gains from profession (such as bonus), capital gains income, and ‘income from other sources’. The government also often provides certain leeway such that various deductions are made from an individual’s income before the tax to be levied is calculated.
Income Tax Returns
Income Tax Returns (ITR) form are the basis of calculating a person’s income tax. It is a statement showing the status of a person, all their sources of revenue, deductions and, lastly, the tax payable or tax refund, if any.
Income Tax slabs
What income tax rate a person pays depends on the slab they fall in. The government has categorised incomes into slabs like — up to Rs 250,000, Rs 250,000-Rs 5,00,000, Rs 5,00,000-Rs 1 million, and more than Rs 1 million. The rates on different slabs might be different based on age groups.
Tax on some components of income can be waived by the government. These tax reliefs are known as standard deductions.
Tax Preparation VS. Tax Planning
Many people expect to save the most amounts of taxes by hiring a professional to prepare their tax return. However, you may be surprised to learn that you could probably get some additional tax savings after your professional tax preparer’s work. Recently, a fellow fee-only financial planner shared a story with us. He reviewed five tax returns prepared by an experienced CPA, and he was able to find extra tax saving opportunities from four out of the five tax returns. Other advisors and I also have the same experience. This week, I am going to explain the difference between tax preparation and tax planning, and how to get some real comprehensive tax planning advice.
First of all, you have to understand that tax preparation and tax planning are different. From a professional perspective, they are technically two different services.
Tax preparation is a service that helps you file your tax returns. The main goal is to make sure your tax reporting complies with both federal and state tax laws.
Tax planning is a service that helps you optimize your tax situation before reporting. The purpose is to use legitimate ways to optimize your potential tax consequences based on your goals and plans for future.
Some professional tax preparers may give you general tax guidance and tax savings advice based on your tax returns for recent years. Or they just answer your specific tax-related questions upon your request. However, many of you may not get proactive tax planning advices from them, such as how to use tax loss harvesting to offset your investment gains, how to manage your tax bracket, how to maximize your charitable deduction in a tax-efficient way, when you should do a Roth conversion, what to do with your stock compensations from the tax perspective, what’s the most tax efficient way to take your money out from all your taxable and retirement accounts, how to strategically qualify for a larger mortgage amount or financial aid from the income perspective, and so on. Why? Mainly because tax planning is a separate engagement, requiring additional information, time and various aspects of knowledge other than tax filing