What is Tax Planning?

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

One of the main focuses of tax planning is to apply current tax laws to the revenue that is received during a given tax period. The revenue may come from any revenue producing mechanism that is currently in operation for the entity concerned. For individuals, this can mean income sources such as interest accrued on bank accounts, salaries, wages and tips, bonuses, investment profits, and other sources of income as currently defined by law. Businesses will consider revenue generated from sales to customers, stock and bond issues, interest bearing bank accounts, and any other income source that is currently considered taxable by the appropriate tax agencies.

In many cases, a primary goal of tax planning is to apply current laws in a manner that allows the individual or business to reduce the amount of taxable income for the period. Thus, planning for taxes involves knowing which types of income currently qualify for as exempt from taxation. The process also involves understanding what types of expenses may be legitimately considered as deductions, and what circumstances have to exist in order for the deduction to be claimed on the tax return.

There are three common approaches to tax planning for the purpose of minimizing the tax burden. The first is to reduce the adjusted gross income for the tax period. This is where understanding current tax laws as they relate to allowances and exemptions come into play.

A second approach to tax planning is to increase the amount of tax deductions. Again, this means knowing current laws and applying them when appropriate to all usual and normal expenses associated with the household or the business. Since these can change from one annual period to the next, it is always a good idea to check current regulations.

One final approach that may be applicable to effective tax planning has to do with the use of tax credits. This can include credits that relate to retirement savings plans, college expenses, adopting children, and several other credits. One common example of a tax credit is the Earned Income Credit, which is intended to relieve the tax burden for persons who earn less than a certain amount within a given calendar year.