Tax Planning or Tax Preparation: Which Do I Need?

The terms tax planning and tax preparation are often used interchangeably, but these professional services are actually very different. Tax planning and tax prep vary in their scope, their goals, and, most importantly, their overall impact on your financial goals.

What is Tax Planning?

Tax planning is a long-term, strategic process that incorporates all aspects of your financial plan. The goal of tax planning is to pay the lowest possible taxes over your lifetime. This includes making strategic financial decisions to minimize your tax liability and employing a tax-efficient investment strategy.

Tax planning is often done with the support of a professional financial planner or advisor, who understands your unique financial situation. Tax planning is a proactive and ongoing process. It takes into consideration the changing tax landscape as you move through life stages such as marriage, children, and retirement. Tax savings may occur in the present or the future. At times it is advantageous to pay more in taxes today, in order to reduce your future tax bill.

What is Tax Preparation?

Tax preparation is the annual process of filing your tax return with the IRS. The goal of tax preparation is to file your taxes correctly in order to avoid penalties.

Some individuals choose to employ a professional to prepare their taxes, while others perform their own tax preparation, often with the support of tax filing software. Most individuals file their taxes between the end of the year and the tax deadline, typically April 15. Tax preparation includes gathering financial documents such as relevant receipts and Forms W-2 and 1099. During the tax preparation process, you determine if you owe additional taxes or are owed a refund.

How do Tax Planning Strategies Differ from Tax Preparation Services?

Tax planning strategies differ from tax preparation services in many key areas, including timing, focus, and professional involvement:

Timing:

• Tax preparation is seasonal. Tax returns are filed annually, thus focusing on a time period of one year. Tax returns are due on a specific day, typically April 15. There is a distinct window for gathering information, filing the return, and paying any taxes owed.
• Tax planning is year-round and ongoing. Tax planning takes into account past, present, and future in order to minimize your tax burden over an entire lifetime. Tax planning is a long-term process and the benefits are not always immediate.

Focus:

• Tax preparation focuses on compliance and accuracy. During tax preparation, you can maximize all available credits and deductions. But, you are bound by taking advantage of what is available, rather than proactively creating new savings opportunities.
• Tax planning focuses on optimization and long-term benefits. By taking into account the entirety of your financial picture, tax planning looks for strategic changes that will create new opportunities to minimize your tax bill. Some of the opportunities identified will result in immediate savings, but others will take years to pay off - in some cases even benefiting the heirs of your estate.

Professional Involvement:

• Tax preparation may be done independently or with a professional. Professional tax preparers will ensure your tax filing is done in a timely and accurate fashion. Skilled professionals may also ensure you are taking advantage of all available tax credits and deductions. Tax preparation does not require an in-depth knowledge of your personal situation. Thus, working with a professional to file your taxes rarely requires more than a couple of meetings or phone calls.
• Tax planning is a complex and highly personal process, best done with a professional partner, typically a financial planner or advisor, or a tax attorney or CPA that specifically offers advanced tax planning services. Solid tax planning requires an in-depth understanding of your complete financial plan. As such, your relationship with your tax planning professional will be much more involved and comprehensive.

What is Included in a Comprehensive Tax Planning Strategy?

There are several strategies to minimize your lifetime tax liability, and comprehensive tax planning takes all of these into account. Which strategies will serve you best depend on your income, investment portfolio, and short-, medium-, and long-term financial goals.

Specific tax planning strategies include:

Income Timing 

Income timing is a tax planning strategy that aims to control your income tax liability by moving taxable income out of, or into, a calendar year. Typically, the goal is to defer taxable income into a future year, and move deductible expenses into this year. However, there are cases when it makes more sense to increase your tax burden in the present, such as if you expect to be in a higher tax bracket next year. In that case, you want to accelerate your income into the current year and save any deductible expenses into the future.

Regardless of your goal, there are several types of income you might be able to move forward or backward in time. This includes bonuses, self-employment income, income from U.S. treasury bills, or retirement plan distributions - outside of what is mandated by early-withdrawal penalties and Required Minimum Distributions (RMDs). Careful planning around when to collect these flexible sources of income can help you stay within lower tax brackets over time.

Tax-Advantaged Savings

Similar to income timing is the strategy of reducing your taxable income through tax-advantaged savings. This includes saving in retirement accounts and HSAs (Health Savings Accounts).

Tax-advantaged retirement accounts include traditional IRAs (Individual Retirement Accounts) and corporate sponsored retirement plans, such as 401(k)s. Traditional IRA contributions are tax deductible and contributions to corporate sponsored retirement plans are pre-tax, so both lower your taxable income. These savings are allowed to grow tax-free until withdrawals are made during retirement, at which point they are taxed as income. Tax-advantaged retirement accounts have a contribution limit that changes slightly from year to year.

HSAs are similar to tax-advantaged retirement accounts in that contributions are tax deductible or pre-tax, growth is tax-free, and there is an annual contribution limit. However, HSAs offer the additional tax benefit that withdrawals are also tax-free, as long as they are used for qualifying medical expenses.

Charitable Giving Strategies

Another strategy to lower your taxable income is charitable giving. A deductible charitable contribution is money or goods given to a federally-recognized, tax-exempt organization, for which you receive nothing in return. There is a limit to how much of your AGI (adjusted gross income) you can deduct for charitable contributions. Typically, you can deduct up to 60% of your AGI, but it may be much lower depending on the situation. Deductions that exceed this limit may be carried over for the next five years, or until they have all been used.

Charitable contributions are itemized deductions, which require more complicated (and potentially more expensive) tax preparation. For a charitable gift to effectively reduce your taxable income, it must exceed the standard deduction. Because of this, charitable giving strategies need to be considered carefully to determine if the gift will create a large enough impact on your tax situation to warrant the extra work of an itemized deduction.

Asset Location Strategies

Income timing, tax-advantaged savings, and charitable giving are all strategies to reduce income taxes. Asset location is a strategy to help reduce investment taxes. To implement an asset location strategy, you spread your investment portfolio across multiple accounts with different tax treatments. The goal is to hold less tax-efficient assets, such as bonds and bond funds, in tax-advantaged accounts, such as the retirement accounts discussed above, and to hold more tax-efficient assets, such as ETFs (exchange-traded funds), in accounts that do not have any special tax treatment. This strategy will help maximize your potential returns by minimizing the amount that will need to go to taxes.

When implementing an asset location strategy, it’s important to have a clear understanding of your entire financial picture. Your tax-saving strategy should not come at a cost to your long-term financial goals. It is important to stay disciplined to your asset allocation and keep your risk capacity, risk tolerance, and time horizon at the forefront of your investment strategy. Because of this, it may be beneficial to work with a professional financial planner or advisor if you are interested in implementing an asset location strategy.

Roth Contributions and Conversions

Making Roth contributions and/or conversions is a tax strategy in which you pay more taxes today with the expectation that you will save on your tax bill in the future. Roth IRAs are retirement accounts that are contributed to with after-tax dollars. The benefit of Roth IRAs comes later - because earnings and withdrawals from Roth IRAs are tax-free (as long as the withdrawals are made after age 59.5).

There are limitations to who can contribute to a Roth IRA, your MAGI (modified adjusted gross income) must be below a certain threshold, and how big the contribution can be. But even if your earnings are over the limit, there are ways to contribute, such as a backdoor Roth IRA contribution or an after-tax contribution to a workplace retirement plan, such as a Roth 401(k), if available.

A Roth IRA conversion is when you transfer retirement savings from a tax-deferred account, such as a traditional IRA, to a Roth IRA. Unlike a Roth IRA contribution, there are no income or contribution limitations. During a Roth IRA conversion, you create taxable income for the current year. Roth IRA conversions may be particularly beneficial in the years between retirement and RMDs, when your earned income is low. In many cases, conversions during this time allow you to pay taxes on your retirement savings in a lower tax bracket and reduce the amount of future RMDs, which are calculated based on your total tax-deferred retirement savings. Because of this, Roth IRA conversions are not only a powerful tax planning strategy, but also an important consideration as part of your retirement income and estate plan.

Tax-Loss Harvesting 

No one likes to see their investment portfolio lose value. But, we know that markets don’t go straight up - there are many ups and downs during a typical market cycle. Tax-loss harvesting is a tax strategy that takes advantage of the downs by using investment losses to offset taxable capital gains.

When you sell an investment that has increased in value, you are selling it for a gain and will incur a capital gains tax. When you sell an investment that has decreased in value, you are selling it for a loss. You can use investment losses to offset the gains, thus reducing your capital gains tax burden. Even if you don’t have any gains to offset, you can still potentially benefit from loss harvesting. Any investment losses that are greater than your investment gains can be used to offset your ordinary taxable income up to $3,000. Additional losses can be carried forward to use toward future income.

Tax-loss harvesting is nuanced (as most tax-related items are), and another good case for working with a professional financial planner or advisor. For one thing, you must use long-term losses to offset long-term gains, before long-term losses can offset short-term gains. Short-term gains are earnings from assets owned for less than one year, which are taxed at ordinary income rates rather than typically lower capital gains rates. Additionally, investors need to be cautious of violating the wash-sale rule. The wash-sale rule prohibits investors who sell a security at a loss from buying the same or a “substantially identical” security within 30 days before or after the sale.

Key Takeaways

Tax planning and tax preparation are related, but distinct professional services. Tax planning is an ongoing, proactive process, done with a professional financial planner or advisor. Tax planning requires a thorough understanding of the many complex strategies available to lower both your income and investment tax liabilities over a lifetime. Tax preparation is the yearly ritual of filing your tax return with the IRS. Tax preparation requires accurate and timely execution in order to avoid penalties or worse - a dreaded IRS audit. While tax planning and tax preparation vary in scope and focus, capable execution of both is critical to your overall financial health.

 

Get Started On Your Tax Planning Strategy Today

 

The views represented are not meant to be construed as advice. Moreover, no client or prospective client should assume that this content serves as the receipt of, or a substitute for, personalized advice from Affiance Financial, or from any other professional. 

Content should not be viewed as legal or tax advice. You should always consult an attorney or tax professional regarding your specific legal or tax situation. 401(k), IRA, and tax rules are subject to change any time.

Affiance Financial does not serve as an accountant and does not prepare tax returns.

 

Sources:

https://www.investopedia.com/terms/t/tax-planning

https://www.kiplinger.com/personal-finance/cpa-vs-tax-planner-whats-the-difference

https://creativeplanning.com/insights/taxes/tax-filing-planning/

https://www.fidelity.com/learning-center/wealth-management-insights/asset-location-minimize-taxes

https://www.nerdwallet.com/article/taxes/tax-deductible-donations-charity

https://www.schwab.com/learn/story/how-to-cut-your-tax-bill-with-tax-loss-harvesting