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Tax planning is about lowering your LIFETIME tax bill

Tax planning, in my mind, is a very specific thing.

You are engaged in tax planning if you have a philosophy and strategy designed to pay the least amount of taxes possible over your lifespan.

I’ll say that again because most people don’t think about paying the least amount in taxes over their ENTIRE life….They think (and have been conditioned to think) that the goal should be to pay the least amount in taxes in each individual year. Right? I mean think about last tax “season”, wasn’t your instinct to find ways that you could lower your tax bill for 2022? 

And I get it, of course, it’s natural! But it’s also shortsighted….it’s the tax version of winning the battle but losing the war. 

I’ll say it plainly: Attempting to pay the least amount in taxes each year, without any consideration of what effect this will have on your FUTURE tax liability, is a recipe for overpaying the IRS over the course of your life. 

Instead, effective tax planning forces you to think about how this year’s tax bill will impact next year’s tax bill, which can impact your tax bill 5 years from now, which will impact your tax bill in retirement etc.

You have to think about your taxes as an evolving, multi-year process in which you are adding/removing income to your “tax bucket” based on how much you will pay in tax as a result (your marginal tax bracket). 

In my experience, “taxes” are the part of the planning process around which there is the most confusion and the least amount of clarity around what constitutes “having a plan.” 

I also think far too many people think they’re engaging in tax planning when they’re engaged in a more basic (but still super important) function like tax compliance or when they’re working with a tax preparer (CPA or enrolled agent) that provides single-year tax “advice.”

Both are important….but neither actually constitute tax planning. So with that in mind, let’s break down what each of these 3 areas of tax awareness actually entails (compliance, advice, and planning.) 

Consider these 3 concepts together as the food pyramid that we all studied in school: tax compliance at the bottom (everyone that files their taxes does this in some manner), followed by tax advice (not as common), and finally followed by tax planning (even less common!) 

Let’s dive in. 

Tax Compliance 

This is simply the process of filing your tax return and making sure you pay the appropriate amount of tax based on your adjusted gross income, marginal tax bracket, and relevant deductions. 

You are making sure that you are compliant with the IRS for the given tax year. A tax preparer (CPA or Enrolled Agent) can/will get this done for you and typically will enter/leave the picture during tax season once your filing is complete. Tax preparation is reactive by definition. You are handing your tax preparer all of the relevant documents (W2, 1099 self-employment income, 1099-R investment statements, Paystubs, family status etc.) and they are simply taking that information and ensuring that the information is processed on your tax return accurately. 

A quick note: getting a tax refund should not be cause for celebration and does not mean that your tax preparer did a “good job.” This just means that you overpaid the IRS throughout the year and gave them a zero interest loan rather than you getting to keep that money and allocate YOUR money as you see fit.) 

If the only time you are speaking to your CPA is around tax time….well, then, you really have a tax preparer and you are not, in any way, engaged in a tax-planning relationship because tax planning happens all throughout the year. There’s not much planning that you can do if you (and your CPA) have no idea what’s happening in your tax world until you collate the documents a month before the tax deadline. 

Now, to be clear, I absolutely think that tax preparation is a valuable service! If you’re thinking about whether to to do your own tax returns or hire a tax preparer to file them for you…you should hire a tax preparer! 

Tax compliance is way too important, in my mind, to leave anything up to chance. If you do your own taxes, you’re filing one return per year and hoping you did it right….a tax preparer does hundreds of returns each year and knows what they’re looking for. 

Again, just my perspective, but if you’re not willing to pay $500 per year to get your taxes done (and you make $150,000+ per year) I think your sense of value and pricing needs updating. 

A few examples of what a tax preparer might find: 

  • You’re taking the standard deduction when you really should be itemizing based on your mortgage interest, state taxes ,and charitable contributions. 
  • You made a Backdoor Roth Contribution and need to file form 8606 to let the IRS know
  • You didn’t take the qualified business income (QBI) deduction even though you were eligible 
  • You made contributions to an HSA but didn’t remember to include those as an above the line deduction

The list goes on and on. 

Tax Advice

I’m defining this as when your tax preparer also gives you advice as to how to lower your tax bill on your current tax return. A proactive tax preparer will be proactive in this way….rather than just input the numbers and file your tax return, they will think through the return and offer strategies, tips, and suggestions for you to pay less in tax…cool! 

So why do I not consider this tax planning? 

If you are only looking at each tax year in isolation, you’re not actually devising a strategy that will mean paying less in taxes over your lifetime. In fact, paying the least amount in taxes each year almost guarantees that at some point in the point you will pay a lot more in tax! The secret to understanding the tax code, is that ALL income will be taxed at some point. Choosing to take a deduction today means adding taxable income later on and foregoing a deduction today (or choosing to pay the tax) might mean less tax later on. 

And just to be clear, the CPA is not doing anything wrong by trying to minimize your tax bill each year. They are hired, in most cases, on a year-by-year basis to help you file your taxes & are conditioned to help you pay the least amount of taxes while they’re working with you….they’re doing their job! Most taxpayers don’t think about their lifetime tax bill and so judge their tax preparer by how much tax they ended up paying and if they “saved them any money in taxes”

So what’s the alternative? 

Tax Planning 

Effective tax planning is about using your marginal tax bracket to your advantage and controlling WHEN you pay taxes based on how much in tax you would pay in tax for the same deduction in different years. 

In years when you are going to be in a lower tax bracket, we WANT to add more taxable income to your bucket and in years when you are in a higher tax bracket and already have a lot of income….we want to find ways to take income out. We want to maximize how much each tax deduction actually benefits you in the year that you take it! 

Paying the least amount in taxes each year (which means only looking at taxes on an individual year basis) prevents you from doing this. I’ll use an example. 

Imagine that this year you take some time off work and are only in the 12% tax bracket as a result. 

Your tax preparer tells you that you can add an additional $5,000 to your Pre-Tax IRA to lower your tax bill and you think “great, I’m lowering my tax bill…sign me up!” 

But if you were looking at lowering your lifetime tax bill, you would think about the opportunity differently. 

You might say, “well, right now I’m only in the 12% tax bracket. This is the lowest tax bracket I’m probably ever going to be in. Why would I want to get an additional $5,000 deduction right now when it would only save me 12% on the dollar? In fact, I want to go the other way. Not only should I put $5,000 more into my Roth IRA and forego the tax savings this year so I can benefit in retirement, I actually am going to convert my $30,000 Trad IRA into a Roth, pay the 12% income tax…and then I’ll have all of this money to take out income-tax free when I go back up to my normal 32% tax bracket.” 

So again: looking at each year in isolation would have you taking a 12% tax deduction instead of looking at a multi-year strategy which would mean benefiting from a 24 or 32% tax bracket on the exact same dollar amount. 

Real, comprehensive tax planning is focused on minimizing your lifetime tax bill. I keep repeating this because, for most people, it requires a total revamping of how you think about your taxes. 

A few additional examples/points:

  1. You should stop thinking about taxes as a “season” (ie: I’m getting organized for tax season) and more of an ongoing conversation to be had throughout the year. 
  2. A tax preparer (CPA/Enrolled Agent) is a great start….but it should be paired with a proactive financial planner. Someone that is looking at what your tax bill will look like at different parts of your life so you can all plan accordingly. 
  3. Investment strategy is not isolated from tax strategy. Taxes impact every aspect of investment management (via tax loss/gain harvesting, tax-sensitive asset allocation, Roth conversions & cash flow opportunities, employer retirement options etc.) 
  4. Estate planning and risk management is not isolated from tax strategy. How you protect your assets and income will go a long way towards lowering your lifetime tax bill (taxable vs. tax free disability insurance planning, using trusts to keep assets out of your taxable estate, maximizing the tax benefits of your charitable giving, being aware of gift/estate tax limits etc.)

Ok, team that should do it for today. As always, if you're ready to become more intentional with your tax planning, feel free to reach out or schedule time on my calendar here for your Right Fit Call.