In the United States and most other developed countries, those who earn income are required to pay taxes. At the same time, many want to explore ways to reduce the amount of taxes they are legally required to pay, which led us to write about the difference between tax preparation and tax planning.
While it might seem that tax preparation and tax planning are similar or even the same, there are some very important differences between the two. A simple way to remember the differences is that tax preparation generally looks backward at events that have already happened, while tax planning looks forward at different scenarios that could reduce future tax liabilities.
In this blog, we will discuss the difference between tax preparation and tax planning and how you can approach your taxes if you want to reduce them in either the short or long term.
Topics in this blog include:
- Tax Preparation
- Tax Planning
- A Few Tax Planning Strategies to Reduce Taxes
- What is Best for Me?
- Taking My Next Steps
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Tax Preparation
Most adults in the United States are required to pay federal income taxes. They also pay state income taxes unless they live in one of the states that do not currently collect state income taxes. These states are Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, Washington, and Wyoming. In this article, we will focus primarily on federal income taxes.
Once a year, those who owe federal income tax are required to file a tax return. Tax preparation involves compiling financial information associated with the previous calendar year. It is looking backward in time at events that have already taken place to document associated financial data and apply the U.S. tax code to determine the amount of taxes a person or couple is legally required to pay. Because tax preparation is for activities that have already taken place, there are limited ways to affect the amount of tax that is now owed for the previous calendar year.
Those with relatively simple situations may choose to do their own taxes using software such as TurboTax®. Some people use companies that specialize in tax preparation services, such as H&R Block. Individuals, households and business owners with a more complex tax situation may pay an Enrolled Agent(EA) or a Certified Public Accountant(CPA) to complete their taxes.
Tax preparation is generally limited to one tax year. The important point is that tax preparation is a look-back in time at events and activities that were completed in the past year and provides little opportunity to reduce the amount of taxes that are now legally owed.
Tax Planning
By comparison, tax planning is quite different from tax preparation. Tax planning involves advanced planning, looking forward in time at scenarios that have not yet occurred. It involves examining a range of possible future options, estimating the amount of taxes due, and selecting the strategy that will result in paying the lowest taxes in the current and/or future years.
Effective tax planning can significantly reduce a client's lifetime tax burden. As Wealth Managers, we leverage advanced tools to evaluate and implement optimal strategies that minimize current and long-term tax liabilities. We make it a point to partner closely with our clients’ tax professionals to provide tailored solutions that align with their financial goals.
The key takeaway is that tax planning is proactive and this strategic foresight can significantly reduce your tax liability.
A Few Tax Planning Strategies to Reduce Taxes
Historically, the strategy was to pay the minimum amount of taxes each year and to do so as late as possible. In recent times, tax planning has become recognized as a key component of effective financial management, giving the ability to optimize financial health while ensuring compliance with tax regulations. By proactively analyzing income, expenses, investments and potential deductions, tax planning minimizes tax liabilities and maximizes after-tax income. Moreover, effective tax planning ensures cash flow stability, mitigates the risk of penalties or audits and aligns financial decisions with long-term goals. Let’s explore a few.
1 - Roth Conversion
The federal tax code permits moving money from a Traditional IRA to a Roth IRA. This is called a Roth conversion. This can be done at any age. When money is moved from an IRA to a Roth IRA, the money being moved is considered taxable income, the same as money earned while working at a job.
The money that is converted from a traditional IRA to a Roth IRA is subject to the Five-Year Rule. It stipulates that to avoid taxes and penalties, the account owner must be age 59.5 or older and the money cannot be withdrawn from the Roth IRA for five years. Our experience has shown that Roth conversions generally work best if one uses non-retirement money to pay the income taxes due from the Roth conversion. If the money is taken out of the traditional IRA to pay the taxes, this results in even more taxes due from the distribution taken.
A Roth conversion has several benefits:
- Once the money is moved from the traditional IRA to a Roth IRA, the money can grow in the Roth IRA and generally can be withdrawn tax-free.
- When an individual passes away, if the money in the Roth IRA is passed on to their children, then the children can generally withdraw the money tax-free. A Roth conversion may result in fewer taxes paid over an individual’s lifetime and, possibly, no taxes paid by their children when they inherit the money. This strategy saves taxes over two generations.
- Taxes are paid in the tax year that a Traditional IRA is converted to a Roth IRA. Given the large federal deficit and debt, we believe tax rates could go up in the future. Taking advantage of current lower tax rates to convert to a Roth IRA ahead of potential tax rate increases can provide a strategic tax benefit.
We use sophisticated software to model scenarios for our clients to evaluate Roth conversions and estimate the future impact on their taxes paid over their lifetime. For some clients, the potential tax savings could be substantial, in the hundreds of thousands of dollars.
2 - Tax-Loss Harvesting
Tax-loss harvesting involves examining one’s investment losses in a year and selling investments with similar gains. This is commonly done late in the tax year. It is especially valuable in years when the stock market has had large gains or is near all-time highs. It can be used to book profits with highly appreciated investments and offset these gains with the losses from other investments.
3 - Maximizing Retirement Plans
As long as an individual is working, we believe it is important for them to evaluate the retirement plans available through their work. Workplace retirement plans allow contributions regardless of income level, offering a significant opportunity to reduce taxable income. Understanding the specifics of your employer’s plan, including any matching contributions, is key. If your company offers a match, contributing enough to secure the full match is typically a smart move, as it effectively adds to your retirement savings at no additional cost. This matching contribution is a valuable benefit that enhances long-term financial growth while lowering your current tax burden.
Retirement plans vary and come with their own rules. For example, both traditional and Roth IRAs come with income limits to qualify. Many people make more than the minimum income limit, so it is important to review individual situations to determine what is best for each person. The maximum contribution limit increases in certain years, so it is important to understand the rules for the current tax year.
4 - Charitable Giving
Depending on individual situations, gifts to charity can reduce taxes. Here are just a few of the ways that charitable giving could reduce taxes.
- An individual can gift highly appreciated securities to qualifying charities to avoid the capital gains tax incurred from selling shares, realizing the gain, then gifting the cash.
- Donor-advised funds (DAFs) can be created by making an irrevocable contribution to the fund. The entire contribution amount can be deducted from your income in the year of the contribution. Then, the funds can be distributed over time to the charities of your choice over several years in the future.
- For those who are 70.5, a Qualified Charitable Distribution (QCD) can be made from a Traditional IRA. A QCD moves money directly from a Traditional IRA to a qualified charity. If monthly distributions (RMDs) from a Traditional IRA are required, the amount of the contribution to a QCD directly offsets the amount required for the RMD. This results in no taxes due on the amount taken out of the Traditional IRA for the contribution to the QCD.
These are just a few of the strategies that can be used in tax planning to reduce tax liability over a lifetime. If this is an area of interest, we encourage our clients to work with both their financial advisor and a tax professional as a team to create the best plan for them.
What is Best For Me?
To determine the best tax planning strategy for you, start by defining your financial goals, including your goals for wealth preservation, leaving money to your heirs and charitable giving.
Some things to consider are:
- If you are working, do you have a retirement plan at work? What are the rules for this plan? What are the available investments in this plan? Does your company provide a matching contribution?
- Is it more important to reduce your taxes in the current year or the total amount you will pay over your lifetime?
- If you have children, would you rather leave them retirement money in a Traditional IRA that will require your kids to pay income taxes on this inherited money, or would you rather your kids receive retirement money in a Roth IRA that they can withdraw tax-free?
- Is giving money to charities one of your goals?
Effective tax planning requires a comprehensive understanding of your financial situation, including income, expenses, investments, and long-term goals. It involves staying informed about current tax laws, credits, deductions, and available tax-advantaged accounts like IRAs or 401(k)s. By forecasting income, evaluating potential tax liabilities, and strategically timing deductions and investments, you can minimize taxes owed.
Tax planning also requires clarity of an individual’s goals and priorities for their life now, into retirement and for their beneficiaries. The goal is to reduce your tax burden and maximize your after-tax wealth, ensuring that you align your financial actions with both short-term needs and long-term objectives, while fully complying with tax regulations.
Taking My Next Steps
If it seems that there is a lot to consider when doing tax planning, you are correct. Furthermore, in some years, there have been changes in tax laws that have affected some of the strategies listed above.
We have found that by effectively using various tax planning strategies, there is the potential to reduce the taxes some will pay over their lifetime by a significant amount. Each circumstance is unique based upon individual goals, priorities and financial situations. Secondly, tax law changes do occur, which could cause impacts that necessitate reviews or modifications to a plan.
If you need help with tax planning, we recommend working with both a financial advisor and a tax professional together to develop a plan aligned with your goals. For our clients at Financial Journey Partners, we recommend you talk with your Wealth Manager to find the best strategy for you and your situation.
We are here to help you make smart decisions to align your money with your goals so you can Enjoy the Journey.
Financial Journey Partners - Partners in Your Financial Journey®
Our Financial Journey Partners office is based in San Jose, California. We have clients that live in many states across the country. If you have questions about your investments or financial situation, call us to schedule time to talk about your specific situation.
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