Tax Planning vs Prepping
Taxes tend to be synonymous with discomfort. Whether we are worried about paying too much, too little, or filing the right forms; tax season brings with it a bevy of headaches. The U.S tax code is increasing in complexity and the constant “legislative updates” and “tax code simplifications” always seem to do more harm than good. With these concerns, clients often struggle to navigate the tax code and as a result reach out to friends, mentors, and professionals for tax advice. Most often, this culminates in either tax preparation services or tax planning.
While the two may sound similar, they differ radically in scope, skill level, and timing. Tax preparation can be done by anyone and is utilized prior to or during tax season to file taxes efficiently and accurately. With the proper state licenses, anyone can be a tax preparer and no professional licensing is required. Tax planning, on the other hand, is a continually evolving process as a client’s life and financial picture develops in scope and complexity. Though no licenses are required for the tax plan, the level of knowledge and skill needed to effectively tax plan is usually only found in CPA and CFP professionals.
Scope will encompass the appropriate considerations for filings or planning. Skill will relate to the planner or preparer, and the requisite skillset or certifications required or preferred. Lastly, timing relates to the frequency of planning or advice required to effectively minimize a client’s income tax liability.
Tax preparation involves a detailed review and reporting of taxable events from the previous year prior to or during tax season. This process is largely retrospective and involves reporting on past activities rather than actively planning to minimize future tax events. Effective tax preparation may involve a handful of exchanges with a tax preparer including W-2’s, 1099’s, and K-1’s, if applicable. To use an analogy: Tax preparation is the report card, not studying for the test.
Tax planning is a largely proactive process involving careful planning, timing, and monitoring of opportunities to reduce a client’s overall tax liability. Tax planning professionals have a quiver full of strategies that may reduce a client’s tax liability based on their life and financial situations including: deduction clustering, Mega-backdoor Roth conversions, and bonus depreciation write-offs. A skilled planner will be able to note possible exemptions, adjustments, and deductions just as a tax preparer might, but the planner will look into the future and help the client strategize about how to efficiently take advantage of these planning opportunities. Having your tax planning and preparation professionals working together will smooth out the typical headaches associated with tax preparation. For instance, if you remember playing telephone as a kid, did it ever work out properly? The increased communication can potentially even reduce your cost since your tax preparer will spend less time getting up to speed on what happened throughout the year.
The skill required of tax preparers and planners can vary wildly. Tax preparers are not required to hold any professional licenses to become a tax preparer and, in fact, only need a state license. They must register with the IRS and represent clients to a suitable standard. Preparers should be skilled in the practice of preparing returns and may have a four-year degree specializing in tax preparation or they may simply be entering your information into an online preparation site, such as TurboTax. Lastly, it is important to note that not all tax preparers are Enrolled Agents and have limited representation rights in the eyes of the IRS – meaning that they can prepare statements but cannot represent clients in audits, payment/collection issues, and appeals. Conversely, a qualified CPA or an attorney will have full representation of a client in the eyes of the IRS. They can represent their client should there be an audit or an issue with payment. This support makes full and proactive tax planning with a tax professional a more advantageous strategy, though likely a more costly one.
Tax planning may be undertaken by a CFP professional with coordination of the client’s CPA and if the client’s situation warrants one, an attorney. Planning professionals will strategize for the long term, utilizing strategies that will minimize lifetime tax liabilities or structure years of high cashflows and taxable events in advantageous sequences. For example, one common application of this involves clustering deductions around a single year, while the client may normally take the standard deduction, a carefully planned and executed clustering strategy every third or fourth year where the client elects to itemize deductions for a larger tax return can yield a higher lifetime savings rate.
Tax preparation is undertaken during tax season (January-April for non-business owners) and skilled tax preparers should find most clients to be routine preparation work. Clients may opt to elect for a delayed tax return due to complexity or other relevant obstacles and then will file by October 15th. Preparation services are likewise engaged once per year during tax season and it is unlikely that clients will have contact with their preparer outside of this time window.
Tax planning is an ongoing and constantly monitored process. Skilled advisors will monitor the legislative environment for looming legislative updates that could increase their client’s tax liability. The buying and selling of property including equity, fixed income, or tangible property all carry with it tax consequences and opportunities to promote tax efficiency. Whenever clients may choose to exercise ISO or RSU’s, there will be income tax consequences that should be accounted for. While a preparer may tally the damage of such events, a planner will strategize about when and how to dispose of and procure assets in a tax advantaged way. This process is ongoing and is not limited to one season as there may be opportunity for returns or growth in the equity or real estate market at any time. While these actions will be reported and filed during tax season, they can and should be anticipated and planned for.
Tax minimization is usually a goal of clients who want to keep more of their hard-earned money, ensuring that they are paying their fair share and not a dollar more. Both tax preparers and planners can help clients realize this reality. Tax planning is a critical, yet often overlooked, aspect to your financial plan. If you’re not sure how tax planning will help you keep more of your well-deserved money, let us help show you.
Written by Devin McCombs