Tax Planning Vs. Tax Optimization
What Is Tax Planning?
If you’re like many people who wait until tax season to focus on taxes, it’s too late for planning. Tax planning designs a customized game plan based off your previous, current, and projected future spending. The right tax professionals know, understand, and stay informed with changes on the IRS Tax Code so they can ensure you’re compliant with the law while reducing your tax liability. They advise you how to spend and report before you do anything. These plans can go as far as 20 years into the future, though it might need a revamp with any tax law changes. This strategy also requires a meeting with a CPA several times a year to ensure you’re making the most of your expenses.
This money-saving tax style isn’t for everyone. Usually, business owners or those with several or complicated income paths utilize this strategy. Most professionals will provide you with a blueprint with their suggestions and how to spend wisely.
While tax planning may cost more upfront, it can also save you much more than traditional tax preparation. Tax professionals spend more time researching and analyzing because it is unique to your situation. This can also ensure you’re staying on the good side of the IRS through the extensive knowledge and research of the professionals while keeping more in your wallet.
Key steps to the tax planning process include:
- Evaluating Your Tax Liability
You need to have a firm understanding of your current and short-term tax liability before you can make long-term tax planning decisions. The United States has a progressive income tax system with seven different tax brackets. You likely already know that the higher the bracket you are in, the greater your tax liability.
- Know Common Tax Deductions and Tax Credits
Thorough tax planning requires knowing which tax deductions and credits you can take. It’s impossible for you to know each one and when they apply, which is why tax planning is best done with a trusted financial advisor. Yet, you should be familiar with common situations that will impact your tax liability. Some examples include:
- Capital loss deduction
- Charitable contributions
- Home office expenses
- Medical expenses over a certain threshold
- Deductions related to IRAs, 401(k)s, and other investments
- Tax breaks for real estate investments
- Understanding Your Investment Choices
Tax planning includes making choices about where you want to save and invest your money for short-term goals and for long-term retirement planning. Once again, your financial advisor will walk you through your options and discuss which types of investments are the best fit for your financial circumstances, but you should have a broad understanding of different types of investments and accounts and the way your contributions impact your tax liability. Some examples include:
- Traditional and Roth Individual Retirement Accounts (IRA)
- Employer-sponsored pension and retirement plans
- Brokerage accounts
- 529 plans, Coverdell Educational Savings Accounts (ESAs), and other ways to save for college tuition costs
- Health Savings Accounts (HSAs)
- Real Estate Investment Trusts (REITs)
What Is Tax Optimization?
When you have a broad understanding of the elements of tax planning such as your tax liability, deductions, and investment options, you can make informed decisions. Part of making tax planning decisions is optimization, which is the process of reducing or eliminating your tax liability through tax-efficient choices. Financial planners engage in tax optimization for their clients in many ways. You can think of tax optimization as one of those choose-your-own-adventure books. You have many choices to make about your financial future. Each choice has a different outcome, some better than others. Tax optimization is the process of making choices that lead to the best outcome for your current and future tax liability.
Some common tax optimization strategies include:
- Retirement Income Planning
Making the best investment and tax planning decisions now require thinking about the amount of income you want when you retire, what age you want to retire, and what
required minimum distribution rules apply to your situation. Tax optimization when planning for retirement income means making the strategic choice to withdraw the most income when they have the lowest tax liability instead of taking money out of tax-deferred retirement accounts when their tax liability is high.
- Traditional IRAs vs. Roth IRAs
Another decision that typically falls under the umbrella of tax optimization is whether to invest in a traditional IRA or a Roth IRA. This also includes converting a traditional IRA to a Roth IRA. When you contribute to a traditional IRA, you receive a tax deduction and taxes are deferred on your account until you take distributions. Conversely, you do not get a tax deduction when you make a contribution to a Roth IRA, but your account grows tax-free until distribution.
- Choosing the Right Investments
Tax planning means you have to understand and make choices about investments, but optimization means choosing the investment vehicles that grow or maintain wealth while reducing your tax liability. Making tax-efficient choices helps plan for the future, but you must also factor in any gains, losses, and fees associated with your investments. Fees and expenses associated with some expenses can cancel out any tax benefits. Unfortunately, many insurance and investment products have high fees that eat up 50 percent or more of expected returns, and they often get taxed at the highest rate as ordinary income.
What is Tax Preparation?
Tax preparation is the process of preparing and filing a tax return. Generally, it is a one-time event that culminates in signing your return and finding out whether you owe the IRS money or will be receiving a refund.
For most people, tax preparation involves one or two trips to your accountant (CPA), generally around tax time (i.e., between January and April), to hand over any financial documents necessary to prepare your return and then to sign your return. They will also make sure any tax reporting on your return complies with federal and state tax law.
Alternately, Individual taxpayers might use an enrolled agent, attorney, or a tax preparer who doesn’t necessarily have a professional credential. For simple returns, some individuals prepare and file their own tax forms with the IRS. No matter who prepares your tax return, however, you expect them to be trustworthy (you will be entrusting them with your personal financial details), skilled in tax preparation and to accurately file your income tax return in a timely manner.