Want to save on taxes? Then you need to know the difference between income tax preparation and income tax planning.
Income tax planning has become a marketing tagline for many financial advisors and wealth managers these days. Scan through most financial advisor websites, and you will have no problem finding language about their “income tax planning strategies.” However, income tax planning is different from income tax preparation. As both a CPA and a CFP® who is frequently asked about income tax planning and income tax preparation, allow me to explain.
What is income tax preparation?
Income tax preparation is the act of filling out the proper IRS forms in order to calculate a taxpayer’s income tax liability and filing the related income tax return with the appropriate agencies. The process begins with a taxpayer sending their documents to a CPA and ends with the CPA signing and filing the income tax return on the taxpayer’s behalf. When people think of income tax preparation, filing taxes or paying Uncle Sam, this is what they usually have in mind.
What is income tax planning?
Income tax planning is the exercise of proactively mitigating one’s tax liability by using the legal, income tax reduction strategies. Income tax planning can generally take on two forms: annual income tax planning using income tax projection software, and long-term income tax planning using financial planning software.
What are the differences between income tax preparation and income tax planning?
The primary differences between the two is the perspective. Income tax preparation is primarily focused on past events. The primary objective is to properly reflect last year’s economic activity on an income tax return. Income tax planning is focused on the future. The primary question being asked is “What can I do now to reduce my income taxes in the future?” You can think of income tax preparation as looking in the rearview, while income tax planning looks though the windshield and down the horizon.
The second difference is one is required, but the other is not. Filing a tax return is a requirement. Income tax planning, however, is optional . Because of this, almost all taxpayers will file an income tax return, but only an enterprising few will do income tax planning to lower their taxes.
A third difference is that income tax planning can give the taxpayer more control over the amount of income tax they will pay. If opportunities exist to reduce the related income tax, these can be explored during income tax planning. However, when doing preparation, little can be done. Generally speaking, other than some possible retirement plan funding options, the income tax planning opportunities disappear once the clock strikes 12 on the New Year. So best to start the planning well before year end.
The last difference is related to when the action is taken. At the very least, income tax planning should be done prior to the end of the year in order to assess the income tax exposure and minimize its negative effects. Taking a longer view, income tax planning should be something a taxpayer does on a regular basis. Life events, tax law changes, and anticipated changes in income should be analyzed over years, if not decades, to ensure that a taxpayers income tax exposure is managed throughout one’s lifetime. Income tax preparation typically happens once a year, usually in the first quarter following the end of the tax year.
How do I start income tax planning?
If you have a CPA that you enjoy working with, ask if they offer income tax planning services. Most, if not all, should have income tax projection software that will allow them to model out your income tax return, and then run various tax mitigation strategies through it in order to reduce your overall income tax liability.
If your CPA does not offer tax planning services, or if you don’t have one, then you may want to find a professional who is both a CPA and a Certified Financial Planner®. These professionals will have the ability to not only do annual income tax projections to mitigate your annual income tax liability, but they will also be able to incorporate your income tax planning into your overall personal financial plan. Chances are, if you are feeling that you have an income tax planning need, then you may want to explore personal financial planning as well. And, if they are CPAs, they will be able to file your income tax returns too. This will provide for maximum planning and efficiency.
About the author:
JP Geisbauer is a Certified Public Accountant and a Certified Financial Planner ®. He is the founder of Centerpoint Financial Management, LLC, a retirement planning, investment management, and tax planning firm located in Irvine, CA. If you have specific questions regarding your situation, please schedule a complimentary 30-minute call here.
Disclaimer:
This article is for general information and educational purposes only. Nothing contained in this article constitutes financial, investment, tax, or legal advice. Before taking any action on any topic discussed in this article, please consult with your financial planner, investment advisor, tax professional, and/or attorney for advice on your specific situation.