Where is Your Priority: Tax Preparation or Tax Planning?

with No Comments

Tax planning is very different than tax return preparation. The goal of tax preparation is to minimize your tax owed this year. The goal of tax planning is to maximize your after-tax net worth by minimizing your taxes owed over your lifetime.

Both are important, but it matters where your priorities are.

Deferred compensation, contributions to traditional retirement accounts, and holding on to your investment gains are staples of tax-preparation-driven thinking. These short term strategies reduce this year’s tax burden sometimes costing you more money in your lifetime taxes owed.

In contrast, tax planning suggests contributing to your Roth IRA, intentionally realizing capital gains each year, and doing large Roth conversions. These strategies increase this year’s tax burden while sometimes also increasing your ultimate after tax net worth.

Take for example Roth conversions.

Imagine you have a traditional IRA with $100,000 in it. Although you originally got to lower your taxes when you contributed, now each time you withdraw from your traditional IRA you owe some tax. And there are Required Minimum Distributions for both you and your heirs, so you will have to withdraw.

Even though your account statement says that your IRA is worth $100,000, it will be worth less after taxes. In practice, your traditional IRA is partially earmarked for you and partially for the IRS. If your withdrawals’ effective tax rate will be 30%, then a simple way to think about this is that your traditional IRA is 70% yours and 30% the government’s.

When your IRA sees a $6,000 return, 30% of that appreciation is not yours. The government’s portion grows by $1,800 and your portion grows by $4,200. And although the growth on your portion may have been mostly capital gains, the growth is all taxed at ordinary income tax rates when it is withdrawn.

It may seem like a wash on the back of a napkin whether you fund your Roth or your traditional and whether you convert to Roth or leave it in traditional. However, in reality, the math favors funding your Roth and doing a Roth conversions even if you are going to remain in the same bracket your whole life.

As we demonstrate in “Should I Fund a Roth or a Traditional Account?” and describe in “Our Customized Roth Conversion Recommendations” there several ways that favoring Roth accounts and conversions help maximize your after tax net worth.

If you fail to keep the cash in your taxable accounts fully invested and appreciating at market rates of return, then the math favors Roth funding and conversions.

If capital gains, dividends, and interest in your taxable account will be taxed, then the math favors Roth funding and conversions.

If you will be in a higher bracket with RMDs, the math favors Roth funding and conversions.

If you’re being hit by AMT, the math often favors large Roth conversions.

Small differences like these upset the balance of being in the same bracket, often in favor of funding a Roth.

Tax preparation misses all of these. Conventional wisdom and simplistic rules won’t find the optimum plan. You cannot find the best Roth conversion plan on the the back of a napkin.

At our firm, tax planning is our priority. We hope to maximize after-tax net worth over your lifetime, even if it is at the expense of this one year.

Photo by Andy Chilton on Unsplash
Follow Megan Russell:

Chief Operating Officer

Megan Russell has worked with Marotta Wealth Management since 2005. She loves to find ways to make the complexities of financial planning accessible to everyone. Her most popular post: The Complete Guide to Your Washing Machine

Latest posts from