What is Tax Planning?
Tax Planning is minimizing your tax liability by making the best use of all available deductions, allowances, rebates, thresholds, etc as permitted by income tax laws, rules stipulated by the government of a country. Tax planning helps in effective cash flow and liquidity management for taxpayers and better retirement plans and investment opportunities.
Types of Tax Planning
Now let’s discuss the 3 different types in detail.
- Periodic Tax Planning – Tax planning can either be of short or longer period of time, if done for less than 12 months is known as shorter period tax planning whereas planning done for more than 12 months is known as longer period tax planning. For example, there are short term and long-term capital gain taxes depending upon the holding period of assets/investments.
- Liberal Tax Planning – Here the planning conforms to law provisions of tax and distinguishes the same with tax evasion or tax avoidance.
- Intended Tax Planning – This method is based on loopholes in the tax laws and unexplored areas.
Examples of Tax Planning
Let’s take some examples to understand this concept.
For married couples or civil partners where one partner is a basic rate taxpayer and the other is a higher rate taxpayer, it is logical that the person who has the lowest income to receive the taxable rental income. This is generally cost-efficient where there is a loan on the property as interest relief will be restricted in future periods.
John is starting a new business and expects to make annual profits of £37,500 before tax and national insurance.
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Consider the financial effect of his choosing to trade as a sole trader or, alternatively, through a company, paying him a salary of £12,500 and then the largest possible dividend not giving rise to a loss of capital. Assume that accounting profits equal taxable trade profits and that alan will be the sole employee and a director of the company. Use 2017/18 tax rates.
Importance of Tax Planning
They can have some great benefits for any business regardless of nature and size, few of them are listed below:
- The main core of tax planning is to reduce the amount of tax you pay by taking full benefit of all available deductions.
- It helps in saving some extra bucks out of your monthly earnings which you can use to invest in other lucrative investment opportunities and generate a handsome amount of returns over that surplus money.
- Eliminate unnecessary stress and uncertainty by knowing just what your tax liability will be and make informed decisions, ultimately obtaining peace of mind.
- The earlier in your professional/business journey you start tax planning, the more strategies you can explore to maximize the effects of tax planning.
- They help in learning about the tips and tricks of tax laws, different tax minimization techniques which ultimately helps in tax compliance and effective adherence to tax laws as stipulated by the government.
- Tax planning when clearly distinguished with tax avoidance/tax evasion leads to lesser interaction with tax authorities and unnecessary litigations as well.
The only minor disadvantage of tax planning is that it could lead to blockage of your money into buying of tax saver products such as ULIPS, Mutual funds, Life insurance, bonds, etc which could impact your short-term liquidity and buying these products just for the sake of tax savings and ignoring other aspects such as annual returns.
Some of the limitations are as follows:
- There is a sort of distrust between the tax authorities on one side and business or professional community on the other. The income tax department thinks that the taxpayers sometimes are unable to distinguish between tax planning and tax evasion/avoidance and misinterpret tax laws as intended by the government whereas the taxpayers think that their money is not being spent appropriately on infrastructure development and sanitation.
- For the salaried class of taxpayers, the responsibility of the correct deduction of tax at source is thrown on the employers. While in the case of a business or profession, they themselves are responsible for declaring correct income. So, an employee may hide his other income and not declare to his employer in order to avoid taxes and business owners also claim excess expense claims and deductions to reduce their tax burden. So in these cases, it takes backstage and tax evasion/avoidance takes center stage.
Changes in Tax Planning
- The consequences of tax changes should be anticipated and considered as you evaluate choices for financial strategies. You can usually be aware of any tax law changes well in advance to incorporate them into your planning.
- Tax deductions, allowances and slab rates tend to change frequently every year as per the economic scenario and taking into government fiscal targets, these changes must be kept in my mind while doing tax planning as a ready reckoner.
- Changes in tax laws are brought in sometimes to boost the economic scenario, infrastructure growth, and industrial development. For example, recently the scope of capital gains tax in the UK for Non-UK residents was extended to include all disposals of UK property. These are just the first in the line of reforms coming down the track in the next few years that will have a significant impact on landlords.
Tax planning has numerous advantages and lesser disadvantages. They should be done within the applicable limits of tax laws and should be clearly distinguished with tax evasion or tax avoidance, both of which are not allowable under the applicable limits of tax laws. Also, any changes in tax laws should be kept into consideration.
They can only be done up to a certain amount limit as per the thresholds fixed by the government tax laws. There are many tax-saving financial products available in the financial markets and those products need to evaluated with pros and cons before buying the same and whether it can actually lead to tax savings or not.
This has been a guide to what is tax planning and its meaning. Here we discuss types and examples of tax planning along with importance & limitations. You can learn more about accounting from the following articles –