When it comes to taxes, a key distinction to make is the difference between tax planning and tax preparation. Tax preparation is a reactive process that primarily consists of reporting what has already happened in the prior tax year to understand your tax liability and whether you’ll receive a refund or owe taxes when you file your return. Tax planning, on the other hand, is a proactive process that involves looking at your overall financial situation, your goals, and your expected future path, to figure out what you can do proactively to minimize your tax liability, not just in a given year, but more importantly throughout your entire lifetime. Keep in mind that just because you have someone preparing your tax return, don’t assume they’re also doing proactive tax planning for you.
Outline of this episode
- An overview of tax preparation [1:18]
- An overview of tax planning [5:15]
- Key things to keep in mind knowing the difference between preparation and planning [8:44]
- Ways to add tax planning to your overall plan [11:05]
- The recap [13:19]
The key difference to keep in mind between tax planning and tax preparation is that tax planning is proactive and involves looking ahead, while tax preparation is reactive based on what's already happened. Tax preparation is about reporting what happened in your financial life over the prior year to the IRS to figure out how much you owe in taxes for the year.
Tax preparation involves gathering tax forms related to your income, whether that's from employment, investments, or other sources (such as a business or partnership), as well as your expenses and tax deductions (things like mortgage interest, property taxes, charitable contributions, and information about your dependents). Based on this information and the government's tax code, your tax preparer is able to calculate what you're required to pay to the government in taxes for the year (which is known as your tax liability). You then compare your tax liability number to what you actually paid in taxes throughout the year (based on withholding from your paychecks, quarterly estimated payments, etc.) to determine whether you'll receive a tax refund or whether you'll have to write a check to the government.
While tax preparation is backward looking and reactive, tax planning is forward looking and proactive. It's about looking at your overall financial situation, your goals, and your expected future path to figure out what you can do proactively to minimize your tax liability not just in a given year, but more importantly, throughout your entire lifetime. Unlike tax preparation, which doesn't impact your tax liability or how much you ultimately pay in taxes, tax planning does have the potential to reduce your tax liability and leave more money in your pocket.
We have several podcast episodes specifically dedicated to tax planning strategies, including episode #3, which focuses on minimizing taxes while you're working, episode #15 that focuses on minimizing taxes in retirement, and episode #23 where we discuss ways to maximize the tax efficiency of your charitable giving.
Understand What You're Receiving
Just because you have someone preparing your tax return, does not mean they are providing planning as well. Due to the nature of the relationship, as well as the typical number of clients, most CPAs or accountants don't have the bandwidth or ability to provide true comprehensive tax planning for their clients. More often than not, you're just paying them to prepare your tax return rather than provide true tax planning advice.
And if you work with a financial advisor (or are considering working with one), you'll also want to do your homework to understand whether or not they provide tax planning. We have an entire episode (#27) dedicated to helping you with that homework by asking the right questions when interviewing a financial advisor.
Resources & People Mentioned
- Podcast episode #3: 6 Ways to Save on Taxes as an Employed Physician
- Podcast episode #15: How to Minimize Your Tax Bill in Retirement
- Podcast episode #23: 5 Strategies for Tax-Efficient Charitable Giving
- Podcast episode #27: The Key Questions You Should Ask a Financial Advisor
- Download our guide: The Toolkit for Optimizing Your Finances as an Employed Physician
- Download our guide: The Financial Checkup