One thing that most people are concerned about is their taxes. People work hard for their money and want to keep as much of it in their pockets as possible. However, taxes come along and take a major chunk of your earnings.
Today, we’re going to discuss tax planning versus tax preparation.
They’re often lumped into the same definition, although they’re two completely different things. Tax preparation is when you put all of your numbers on a tax form or add it into TurboTax or something similar, and you pay the amount you owe to the IRS.
However, if you’re in retirement and on a strict budget, tax planning works to save you money on the taxes you need to pay.
We recommend tax planning for everyone because it saves you a lot of money.
Tax Preparation Basics
When you have your taxes prepared, it goes something like this:
- You file your own taxes, use software or hire a CPA
- Based on the calculations, you pay the taxes for the previous year
In 2022, you’re paying your 2021 taxes. All of the preparation happens the following year after the money is earned, and there’s no real planning involved.
This is where tax planning could have helped.
How Tax Planning Differs
Tax planning happens for the tax year. For example, if you want to save money on your taxes when you file in 2022, planning needs to occur in 2022, not 2023. Tax planning is a proactive approach taken during the year to reduce taxes.
Otherwise, there are only so many ways to reduce your tax burden in April if you didn’t plan for it throughout the year.
For example, let’s assume that you made a ton of money in 2022, received a great bonus and will need to pay a lot of money in taxes. If you engage in tax planning, you may be able to reduce your taxes when you file in 2023 by:
- Using charitable contributions
- Roth conversions
And if done correctly, tax planning can be done over the course of years to reduce your taxes drastically.
Tax Planning Strategies to Save You Money
Reduce Taxes on Social Security
Many people entering retirement don’t understand that they have to pay taxes on their Social Security income. While there are some exceptions to this rule, many of you reading this will still need to pay money to the IRS based on the benefits you receive.
If you make an income in retirement, somewhere around $40,000 for a married couple filing jointly, you will have to pay taxes on up to 85% of your Social Security benefits.
Tax planning can help you reduce your tax burden.
Let’s step back for a moment and consider how people plan for retirement. Many people save for retirement using:
- Traditional IRA
Using these accounts, people plan to supplement their Social Security benefits. However, when you paid into these accounts, you didn’t pay any taxes. You’ll now need to pay taxes when you withdraw from these accounts.
Let’s assume that you take $30,000 out of the IRA per year to supplement your income.
Now, you have $30,000 of income that is taxable and $40,000 in Social Security benefits. Since you “earned” an income from these retirement accounts, you’ll need to pay higher taxes. Utilizing the right strategy, you can move money out of these tax-deferred accounts into accounts where you pay taxes first, but when you make withdrawals in the future, you don’t have to claim the income.
If all you have in income is your Social Security, you’ll:
- Pay less in taxes
- Pay less in Medicare premiums
However, tax planning in this scenario needs to take place 5 or 6 years before you plan to retire.
Roth Conversions to Reduce Taxes
Roth conversions are one of the best ways to get your tax-deferred money out of your 401(k) and Traditional IRA and into an account that allows you to have income in retirement but not pay taxes on it.
In fact, using this strategy, most of our clients earn the same or even a higher income in retirement than when working.
But here’s the problem.
- Tax-deferred accounts mean you pay less taxes now and more taxes when you make withdrawals
- People assume that when they’re in retirement, their income will be lower, so they’ll pay less taxes
- Based on this assumption, people think a tax-deferred account is the best option to pay less taxes
The problem is we’re seeing people earn more in retirement than when they’re working, causing them to pay higher taxes because they’re in a higher tax bracket.
And you have to start taking a required minimum distribution (RMD) at 72 and a half due to tax laws.
Instead, a Roth conversion works like this:
- Roll pre-taxed money into a taxed account
- Convert money into a tax-free bucket
- Reduce your long-term taxes
Let’s assume that you have $1 million in a tax-deferred account. When you convert to a Roth account, you’ll pay taxes on the $1 million. However, the money can now grow tax-free, meaning as the account grows, you don’t have to worry about taxes.
We know that if tax laws do not change, everyone is going to pay higher taxes in 2026.
If you convert to a Roth account, you’ll pay taxes today and avoid the higher taxes that are coming in just a few years.
Tax planning helps you account for all of these factors, save money when you’re in retirement, and have a lot less to worry about as a result. Tax-free buckets are ideal for everyone planning to retire because your money can grow tax-free.
And we have one last tax planning strategy that we must discuss: planning for your surviving spouse.
Planning for Your Surviving Spouse
In 99.99% of marriages, someone is going to outlive their spouse. Of course, there are the rare occasions when spouses pass on the same day, but this often involves a very tragic occurrence. Tax planning for your surviving spouse is not something many people want to think about, but it’s a way to ensure your spouse is financially stable when you’re no longer here.
When you pass, your spouse needs to file as a single person, and this does a few things:
- Increases tax burden
- Reduces standard deductions
Setting up a tax-friendly account for your spouse is the best option if you don’t want to transfer money to the IRS. Planning ahead allows you to save your spouse money on taxes and ensure that they have the income necessary to live comfortably after you’re gone.
Work with a CPA or us (click here to book a conversation) to start working through in-depth tax planning to save you and your spouse money on their taxes.
One last thing before you go: