It’s officially October, which means year-end tax planning will start picking up over the next few months. The end of the year is an ideal time for many financial moves that can positively affect your tax situation. Unfortunately, many people don’t recognize the value of tax planning throughout the year, let alone at the end of the year. If for you “dealing with taxes” means talking to your CPA in April each year, then you could be missing out. Tax preparation and tax planning are very different, and understanding the difference has the potential for you to save thousands on your lifetime tax bill.
Key Takeaways
- Tax preparation is ensuring you meet all your personal and business “tax requirements” from the past year.
- Tax Planning should be something business owners are doing year-round and is not just finding deductions; instead, it is intentionally altering your financial picture with taxes in mind.
- Business owners should be tackling tax preparation and planning annually and should seek accountants adept at both.
What is Tax Preparation?
Tax preparation (as opposed to planning) is what most people think when they articulate what an accountant does for them. “He does my taxes” is the popular phrase here. More or less, someone is responsible for making sure you meet all your “tax requirements” from the past year.
One of a personal accountant’s major roles is to review your personal and business situation from the past year and help you report and pay the appropriate amount of tax. They organize your income, deductions, available credits, and more to build the tax returns required by the IRS. The main goal is accurate, complete reporting and filing over time.
In a perfect world, your accountant would have all the financial and tax information needed on January 1st, and then fill out your returns and additional forms required to comply with the IRS. If done perfectly, then you wouldn’t need to talk to your CPA again until the following January.
Unfortunately, we all know this is not possible. Even looking into the past to accurately record your tax history takes attention and months of work to accomplish. 1099s come out, K-1s are issued, and W-2s get mailed all at different times throughout the tax preparation process. Extending tax returns is also a big topic here, where many people will extend their business returns as late as September or October of the following year.
The best accountants can keep track of all these moving parts, and their tax preparation process makes it easier to stay compliant with everyone you must report to and pay taxes to. However, the important distinction is that no matter how well you track the past, it doesn’t help you much with the future. Tax preparation is more of a process to discover how much tax you owe, not a process that attempts to reduce your taxes going forward. That is where tax planning comes in.
What is Tax Planning?
High tax bills are one of the most common issues in personal and business finances alike. After a few years of the “discovery process” of tax preparation, many business owners and high-income families ask what they can do to reduce their taxes. Especially for those with more complex situations or variable revenues/incomes each year, it can be hard to stay on top of your tax situation.
Tax planning is about making intentional decisions before it is too late that legally and positively reduce your tax bill. This can include the current tax year but also future years. Taking it to the extreme, it means trying, in the best way possible, to reduce your lifetime tax burden. However, the goal is not simply to pay less tax. Instead, the goal is to make smart financial decisions with taxes in mind. Doing so can, by default, potentially help lower your tax bill.
For example, towards the end of the year, we help many clients with Roth Conversions. This is a strategy where we purposely take money out of a Traditional IRA, pay the taxes, and convert the proceeds to a Roth IRA to invest. In order to make this call, we must plan to ensure that this current tax year is arguably a better time to distribute the IRA and pay the taxes. If we reasonably expect your tax rate to be lower this year than in future years, it could make sense to purposely pay taxes now, since it would be less than paying them later.
Do you need both Tax Preparation and Tax Planning?
There are as many tax planning strategies as there are tax preparation requirements, depending on the situation. Reviewing income sources, deductions, credits, depreciation, retirement contributions, business structures, charitable giving, and many other areas all have the potential to add value from a tax planning perspective. Again, tax planning is looking forward, understanding that things are inevitably going to change.
Tax Preparation is required in the modern economy. You need to make sure you file correctly and pay the taxes you owe. The more complex your tax preparation process, the more important and valuable an accountant can be.
Tax Planning should be something business owners are doing year-round, since we still have some control over our business, income, expenses, deductions, contributions, retirement, gifting, etc. Planning is not just finding deductions that you are already doing (and probably not getting credit for). Instead, it is intentionally altering your financial picture with taxes in mind.
If your accountant has been primarily focused on tax preparation for your situation, it may be time to upgrade to a tax planner. That could be as simple as asking your accountant if they do tax planning. Some accountants are amazing tax planners, while others do not have the time or expertise. If you work with a financial advisor, make sure they’re part of the tax team. For our clients, we are generally leading the conversations about Roth Conversions, S-Corp designations, retirement contributions, charitable giving, and so on. Then we partner with accountants to ensure each recommendation fits the specific situation.
What Should You Do Next?
Both tax preparation and tax planning are vital for business owners. Proper organization and reporting are needed for the unnecessarily complex tax system we operate in. Do your best to ask both your accountant and your advisor about your tax situation. Identify which areas of your personal and business finances need to be “uncovered” from a preparation standpoint. And then ask what planning opportunities you may have for the future. Don’t assume that filing an accurate return means you have considered every available planning opportunity, or that you are doing everything you can tax-wise. If you are not doing year-round tax planning, there could be some missed opportunities you are ignoring.
