What Are the Steps in the Tax Planning Process?

Tax planning is the analysis of a financial situation from a tax perspective, allowing you to legally arrange your affairs to reduce your tax liability. It is a proactive process that occurs throughout the year, involving strategic decisions about income, deductions, and investments. This approach contrasts with tax preparation, which is the reactive process of filing returns based on events that have already happened. By considering tax implications before making financial choices, you can structure transactions for a more favorable result.

Gathering Your Financial Information

The first step in tax planning is to collect all relevant financial documents. This information provides a complete picture of your financial activities and serves as the basis for all subsequent analysis. A starting point is your prior year’s federal and state tax returns, which offer a baseline for projecting the current year’s liabilities.

You will need to assemble all records related to your income for the current year. This includes:

• Recent pay stubs to estimate annual wages and tax withholding.
• Form 1099-NEC for independent contractor work.
• Form 1099-INT for interest and Form 1099-DIV for dividends.
• Form 1099-R for distributions from retirement accounts.
• Brokerage statements detailing capital gains and losses.
• Form 1098, the Mortgage Interest Statement, for deductible interest and property taxes.
• Receipts for charitable contributions and records of medical expenses.
• Form 1098-T for education credits and Form 1098-E for deductible student loan interest.

Analyzing Your Current Tax Position

Once you have your financial documents, the next step is to project your current year’s tax situation. This involves calculating an estimate of your total income and then subtracting applicable adjustments to arrive at your Adjusted Gross Income (AGI). Your AGI is a key figure that determines your eligibility for certain tax deductions and credits.

From your AGI, you subtract either the standard deduction or your total itemized deductions to determine your taxable income. You will use whichever method results in a lower taxable income. Itemized deductions include expenses such as mortgage interest, state and local taxes up to a $10,000 limit, and charitable contributions.

With your estimated taxable income, you can apply the federal income tax brackets to calculate your projected tax liability. It is important to understand your marginal tax rate, which is the rate you pay on your last dollar of income. This rate shows how much tax you will save for every additional dollar you can deduct from your income. For example, if you are in the 22% marginal tax bracket, a $1,000 deduction will save you $220 in federal income tax.

Identifying and Evaluating Tax Planning Strategies

After analyzing your current tax position, the next step is to identify and evaluate strategies that can legally reduce your tax liability. The goal is to select options that align with your overall financial objectives.

Retirement Savings

One of the most common tax planning areas involves retirement savings. Contributions to traditional, tax-deferred retirement accounts, such as a 401(k) or a traditional IRA, are often made with pre-tax dollars, which reduces your taxable income. For 2025, you can contribute up to $23,500 to a 401(k), with an additional catch-up contribution of $7,500 for those age 50 and over. For those aged 60 through 63, this catch-up limit increases to $11,250.

In contrast, contributions to a Roth 401(k) or Roth IRA are made with after-tax dollars and do not provide an immediate deduction, but qualified withdrawals in retirement are tax-free. The choice between traditional and Roth accounts depends on whether you expect your tax rate to be higher now or in retirement.

Investment Management

Strategic management of your investment portfolio can also yield tax benefits. Tax-loss harvesting involves selling investments at a loss to offset capital gains. If your capital losses exceed your gains, you can use up to $3,000 of the excess loss to offset ordinary income each year. You must be mindful of the “wash-sale” rule, which prevents claiming a loss if you buy a “substantially identical” security within 30 days of the sale.

Another investment strategy is asset location. This involves placing investments that generate high taxes, like corporate bonds, into tax-advantaged retirement accounts. More tax-efficient investments, such as stocks held for long-term growth, can be held in taxable brokerage accounts to benefit from lower long-term capital gains tax rates.

Income and Expense Timing

Controlling the timing of when you recognize income or pay expenses can be a useful tool. If you anticipate being in a lower tax bracket next year, you might consider deferring income, such as a year-end bonus, until the new year begins. This pushes the tax liability on that income into a year where it will be taxed at a lower rate.

Conversely, if you expect to be in a higher tax bracket next year, you might accelerate deductions into the current year. This could involve prepaying deductible expenses like property taxes or making your January mortgage payment in December. The goal is to shift income into lower-tax years and concentrate deductions in higher-tax years.

Maximizing Deductions and Credits

A final area of focus is ensuring you take full advantage of all available deductions and credits. For those who itemize, “bunching” can be effective. This involves consolidating multiple years’ worth of deductible expenses, like charitable contributions, into a single year to exceed the standard deduction threshold.

Tax credits are particularly valuable because they reduce your tax liability dollar-for-dollar. It is important to review your eligibility for common credits, such as the Child Tax Credit, education credits like the American Opportunity Tax Credit, and credits for energy-efficient home improvements, as many have income limitations.

Implementing Your Tax Plan

Once you have decided on a course of action, the next step is implementation. If your plan involves adjusting your paycheck withholding, you will need to submit a new Form W-4 to your employer. The IRS’s Tax Withholding Estimator tool can help determine the correct adjustments.

For strategies involving retirement or health savings accounts, you must take direct action with a financial institution. This may involve contacting your brokerage firm to authorize a transfer of funds into an IRA or working with an HSA administrator to set up contributions. These actions are often completed through the provider’s online portal.

If your plan requires you to make estimated tax payments, you must submit them to the IRS according to a quarterly schedule to avoid underpayment penalties. Payments can be made online through IRS Direct Pay or by mailing a Form 1040-ES voucher.

Executing investment-related strategies also involves specific steps. For example, tax-loss harvesting requires placing a sell order for one investment and a buy order for a different, non-identical security to maintain your asset allocation without violating the wash-sale rule.

Monitoring and Updating the Plan

Tax planning is a dynamic process that requires regular attention. After implementing your plan, it is important to monitor your financial situation and make adjustments as needed, especially toward the end of the year.

Life events are a primary trigger for re-evaluating your tax plan. Significant changes such as getting married, the birth of a child, a job change, or starting a business can alter your tax picture and require an update to your plan.

Changes in tax law also require a review of your strategies. Tax legislation can be altered, with new provisions enacted and old ones expiring. For example, many provisions of the Tax Cuts and Jobs Act of 2017 are set to expire at the end of 2025, which could lead to changes in tax rates and the standard deduction. This annual cycle of planning and monitoring helps manage your tax obligations effectively.