What It Is:
Tax planning is the process of forecasting one's tax liability and formulating ways to reduce it.
How It Works/Example:
Tax planning entails creating portfolios or circumstances that are as tax efficient as possible. This requires investors and companies to give consideration not just to the size of their incomes or profits, but also to the nature and timing of purchases, insurance coverage and the types of investments they make. These decisions affect everything from which tax bracket an investor is in to the types of tax deductions the investor qualifies for.
Tax planning is one reason investments such as Individual Retirement Accounts (IRAs) are so important to many people who are saving for retirement. Assets in a traditional IRA can grow tax-free while the assets remain in the account. So, for example, if John's IRA is invested in Company XYZ stock and Company XYZ stock pays $1,000 in dividends, John does not have to pay the dividend tax that investors who held Company XYZ outside of an IRA would likely have to pay. And because he doesn't have to take money out of the account to pay those taxes, that leftover money is now able to keep growing.
Why It Matters:
Tax planning can make a major difference in the future value of a portfolio and thus have a major impact on a person's standard of living now and in the future. For example, if the scenario described above plays out year after year, John's investment in Company XYZ could be worth much more (thanks to tax planning) than it would be worth if he made the same investment outside of an IRA.