Common Pitfalls of Tax Planning
Tax planning is a complex activity. It is often said that taxes are the number one expense for every middle-class American household. The same situation may also be true in a lot of other countries. This is the reason why tax planning is considered to be an important part of overall financial planning.
There is an entire industry that has been built around tax planning. There are special financial products that allow for maximizing the tax deductions. Also, there are tax experts who help people in utilizing these products to the fullest extent, thereby minimizing their taxes. However, people tend to make several mistakes during tax planning. The end result is that in the short run, they end up saving taxes. However, in the long run, these mistakes prove to be expensive.
In this article, we will discuss some of the common pitfalls which are associated with the process of tax planning.
Borrowing Too Much
The first pitfall that taxpayers should be warned about is related to taking on too much debt. In many places around the world, a certain type of debt is incentivized. For instance, people who take on a housing loan can claim a tax deduction from their expenses. The same is the case for other products such as car loans for environment-friendly cars etc. Hence, it is common for many taxpayers to take on too much debt just for the sake of saving taxes. This is where their budgets end up becoming lopsided.
In the earlier parts of this module, we have already discussed how people can become house poor and how car loans can wreck the finances of an individual. Hence, it is important to stay wary of marketers and so-called tax planners who encourage their clients to take on too much debt.
Planning around Legislations
A lot of people plan their entire finances around certain tax legislation. As mentioned above, a lot of people buy homes because there is a tax deduction attached to them. The same is the case with medical as well as life insurance. However, it is important to buy products because you need them and only then take the benefits of the taxes.
If you buy products just for the tax benefit, you might lose out because the legislation related to these expenses keeps on changing from year to year. If you buy a house for the tax benefits and then the tax benefits reduce or get changed, you might end up being stuck in a wrong financial decision.
Locking Up Assets for Too Long
Liquidity should be an important parameter when a person selects an investment to make for the purpose of tax planning. Generally, the liquidity is inversely proportional to the return offered on the investment. This is because if the borrower can be sure that you will not demand the money back in the short term, then they can invest it in long term projects and give you better returns. Hence, in the pursuit of the highest returns, people often tend to make investments with very little liquidity. This can be a huge mistake since the purpose of personal finance is to ensure that the money required for meeting the life goals is available at the required time. Liquidity is an important part of this goal.
Not Maximizing Retirement Related Deductions
Some of the best benefits of tax planning can be seen in the area of retirement planning. This is because, in many parts of the world, companies are no longer offering defined benefit pension plans. Instead, the pension plans are market-linked. This is the reason why governments have been forced to offer tax benefits to such plans.
In many cases, the investment made by the investor is matched by their employer up to a certain amount. Also, the investments are allowed to grow tax-free for a long period of time which helps them compound at a faster rate. Hence, the first priority for tax savings should be given to retirement funds. However, since these funds get locked in for a long period of time, there are many people who do not prioritize investing in retirement funds.
Lastly, it is important to consider the transaction costs of some of the financial products which are commonly used in tax planning. Some of these products require investments in equity which need to be managed actively. Here, asset management companies often charge a lot of fees for the services they provide.
In many cases, the investor ends up paying too much as a fee and earning sub-optimal returns. In order to mitigate this issue, it is advisable that the investor carefully consider the transaction costs as well before making a decision.
The bottom line is that tax planning is a secondary consequence of overall financial planning. It is important to not forget that money has to be allocated in certain ways to meet the life goals of an individual. If there is a conflict between tax planning and overall financial planning, the overall plan should be given precedence. Tax saving is a secondary goal in the larger scheme of things.
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The article is Written By Prachi Juneja and Reviewed By Management Study Guide Content Team. MSG Content Team comprises experienced Faculty Member, Professionals and Subject Matter Experts. We are a ISO 2001:2015 Certified Education Provider. To Know more, click on About Us. The use of this material is free for learning and education purpose. Please reference authorship of content used, including link(s) to ManagementStudyGuide.com and the content page url.
- Importance of Personal Finance
- Process of Financial Planning
- The Financial Life Cycle
- Three Types of Income
- Misconceptions about Personal Finance
- Macro-Economic Factors and their Effect on Personal Finance
- Going From Financial Goals to a Financial Plan
- Components of a Financial Plan
- Personal Financial Statements
- Advantages and Limitations of a Budget
- Ratio Analysis in Personal Finance
- Dollar-Cost Averaging
- Pitfalls of Dollar-Cost Averaging
- Value Averaging Method of Investment
- The Rent vs. Buy Decision
- Financing Your Home
- Fixed-Rate Mortgage vs. Adjustable Rate Mortgage
- The Phenomenon of House Poverty
- 5 Step Retirement Planning
- Retirement Basics: 401K Plan
- Retirement Basics: Roth IRA
- Auto Loans and Personal Finance
- Earnings Power in Personal Finance
- Personal Financial Planning For Small Businesses
- Common Pitfalls of Tax Planning
- Zero Based Budgeting System Using Envelopes
- The Concept of Financial Freedom
- The Financial Independence Retire Early (FIRE) Movement
- How Do People Save Large Percentages of Their Income?
- Rich Dad Poor Dad Philosophy
- The Pay Yourself First Principle
- Personal Finance Lessons from Rich Dad Poor Dad
- Estate Planning in Personal Finance
- 7 Personal Finance Mistakes to Avoid