Is it Time for Tax Planning … or Tax Optimization? (Know the Difference.)

Mar 22, 2024Taxes

Understanding and figuring out your taxes can be challenging, whether you decide to file them yourself or work with a financial advisor or bookkeeper. While it is not impossible to fix your taxes yourself, most people need some tax help and guidance, especially when understanding tax jargon. Emerald Expectations’ Kimberly Ferguson is committed to just that – demystifying complicated tax terms and topics so that small business owners can better grasp their finances and taxes. One great example is the DIY Bookkeeping Den, an all-in-one introduction to accounting course and coaching package. Here, Kimberly’s goal is to teach small business owners how to DIY their books as their company grows. Part of making taxes more accessible and understandable is defining tax terms and jargon. In this article, we will discuss two tax topics that seem similar at first glance but are actually different from each other – tax planning and tax optimization.

Tax Planning

Tax planning is the strategic process of a taxpayer arranging their financial affairs to optimize tax efficiency while remaining compliant with tax laws and regulations. Put simply, tax planning means analyzing a taxpayer’s financial situation carefully to pay the lowest taxes legally possible. So, the primary goal of tax planning is to minimize the amount of taxes to be paid by making the most of available deductions, credits, exemptions, and other tax-saving strategies. There are several tax planning strategies that small business owners (like yourself) can and should employ:

1. Explore and maximize tax credits

A tax credit is an amount that a taxpayer can subtract directly from owed income taxes, dollar for dollar. For example, if you owe $10 income tax and get a tax credit of $10, you pay $0 taxes. If you owe $10 and get a refundable tax credit of $12, you pay $0 taxes plus receive $2 from the government. Keep in mind that a tax credit differs from a tax deduction, which lowers a taxpayer’s taxable income. There are three types of tax credits: nonrefundable, refundable, and partially refundable. Nonrefundable tax credits can reduce the taxes you owe to zero, but you don’t get a refund. Refundable tax credits are paid in full, giving taxpayers a cash refund of any tax credit beyond the taxes owed. There are several types of tax credits granted by the federal and state governments. One commonly used refundable tax credit is the Earned Income Tax Credit, which workers who meet specific requirements can claim. For example, self-employed people, grandparents raising their grandchildren, veterans, and children with disabilities, among others, who work and have an income of $63,398 or less can file for the Earned Income Tax Credit. Other types of tax credits include Adoption Credit, Child Tax Credit, Family and Medical Leave Credit, and Lifetime Learning Credit. Many people can save thousands of dollars each year by filing for tax credits.

2. Timing income and expenses

Another tax planning strategy is to schedule your income and expenses. When you delay payments owed to you until the following year, or after December 31, you are deferring earned income into the next tax year, which can lower your taxable income for the current year. While it doesn’t lessen the overall taxes to be paid, it reduces your tax liability for the year. By deferring income to the following year, you have more time to plan for and employ various tax planning strategies to lower next year’s taxable income. It gives you more time to work with a financial advisor or tax expert for next year’s taxes.

3. Start a retirement plan or contribute to a retirement account

Tax planning can also mean thinking of the future and contributing to a retirement fund. Saving money and contributing to a retirement plan is another way to reduce the taxes you need to pay. Retirement contributions are tax-free, and the amount is also removed from your taxable income. While there’s a limit to how much you can contribute to your retirement fund, this is a great way to save on taxes in the present and build tax-free savings for the future.

4. Review your current business entity

Take a look at your current business entity, such as an S Corp, LLC, or sole proprietor. Each type of entity has different tax requirements. Evaluate if your tax structure is still working for you and allow you to lessen your taxes as much as possible. For example, if your entity is currently an LLC, you may want to convert it to an S Corp to gain tax savings when you save money on self-employment taxes. Choosing your business entity is one of the most important decisions you’ll need to make when it comes to paying your taxes.

When should I start tax planning?

You might be wondering when the best time to start tax planning is. The best time of the year to engage in tax planning is now! Actually, the earlier, the better. However, if you’re looking for a specific month, any time of the year is good, but ensure you start a few months before December 31, such as September or October. By January 1 of the following year, you can no longer use some tax strategies that can lower your taxes for the year. Most financial advisors recommend reviewing your tax plan at least once a year, even quarterly if possible. Don’t start planning when taxes are almost due or if a problem arises. Be proactive and plan ahead of time. Emerald Expectations has several packages to help you with your tax planning needs. And in case you’re wondering, yes, tax planning is legal. It simply involves having a deep knowledge of tax rules and regulations to save the most on your taxes while fully complying with the law. Some people even consider it the art of reducing one’s tax liability using all legal means possible.

What is tax optimization, and how is it different from tax planning?

Tax optimization is another tax strategy that falls under tax planning, which is considered more of an umbrella term. The key difference is that tax optimization refers specifically to investment-related decisions to help achieve the most favorable tax outcome possible within legal boundaries. Similar to tax planning, there are several tax optimization strategies that small business owners should be aware of and can consider using during the next tax season:

1. Home office deductions

Small business owners can claim home office deductions, although many people miss out on this tax optimization strategy. This deduction is available to all types of homes, owned or rented. An investment in your home office can help you pay lower taxes. To claim a home office deduction, your home office must meet these two requirements:

  • Regular and exclusive use for business purposes—A guest room/home office/playroom in one room is ineligible for this deduction. The space must be used only as a home office.
  • Principal place of business—Your home office must be your primary place of business, meaning you don’t have another office elsewhere. All management activities, such as making sales calls, bookkeeping, and setting appointments, must be conducted in this room.

2. Retirement income planning

Similar to the retirement section above, planning for retirement is also a tax optimization strategy. Adding to a retirement plan helps lower your tax rate. If you’re a small business owner with employees, you can also set up a 401(k) for them and claim the cost of setting up and administering each 401k plan for the first three years of the plan, which also lowers your tax rate.

3. Tax-Loss Harvesting

If you have investments, tax-loss harvesting involves using the losses from an investment to offset gains (or profit) from the sale of another investment, lowering the federal tax the investor needs to pay. The IRS allows this, and this practice is legal. Conditions must be met before you can use this tax optimization strategy. Investments that qualify for this strategy include tradable stocks, bonds, shares, and cryptocurrencies. This strategy can become quite complicated, so it’s best to talk to a tax expert about it.

Who Can Benefit

There are several other ways of using tax optimization strategies to help you lower your taxable income. It’s important to talk to a trusted financial advisor or tax expert to ensure you can maximize the tax breaks and benefits the government offers while staying compliant. All small business owners can benefit from tax optimization, a fully legal and compliant way of creating the most favorable tax outcome for anyone. While you may think tax optimization is only for high-income earners, for example, those who buy a yacht and register it in a country where foreign income is tax-exempt, any taxpayer can use different tax optimization strategies. Tax planning and tax optimization can be confusing, but Emerald Expectations is here to help. Kimberly and her team are experts at tax strategy and can help you lower your taxable income through legal and fully-compliant methods that give you peace of mind while leaving a little more money in your pocket.

Hi, I’m Kimberly.

Thanks for stopping by. At Emerald Expectations, we love making a big impact on small businesses like yours by educating, growing profits, increasing cash flow, and reducing your tax liability.

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