Tax Planning vs. Tax Optimization (Key Differences)

Building wealth and protecting assets require a clear financial plan that evaluates your current financial situation and predicts what your future finances might look like based on the financial decisions you make. Financial planning is a broad term that includes a variety of information about your financial fitness and future financial goals, such as cash flow, assets, sources of income, investments, and retirement plans. Tax planning falls under the umbrella of financial planning with tax optimization as a crucial piece of tax planning. 

Below we offer more in-depth information about tax planning and tax optimization, so you have a better understanding when making decisions about your financial future with the help of your trusted Bogart Wealth advisor. 

What Is Tax Planning? 

Tax planning is a necessary part of financial planning. If you don’t actively plan how to deal with your tax burden, you risk losing any gains you’ve earned, making it difficult, if not impossible to build wealth. Tax planning specifically refers to analyzing and creating actionable steps for your financial future in light of your tax burden. Those concerned with financial fitness and building wealth invest ample time in tax planning to ensure they are making tax-efficient decisions about investments and retirement planning. A thorough tax plan reduces current and future tax liability, allowing you to meet your financial goals. Key steps to the tax planning process include: 

1. Evaluating Your Tax Liability 

You need to have a firm understanding of your current and short-term tax liability before you can make long-term tax planning decisions. The United States has a progressive income tax system with seven different tax brackets. You likely already know that the higher the bracket you are in, the greater your tax liability. 

2. Know Common Tax Deductions and Tax Credits 

Thorough tax planning requires knowing which tax deductions and credits you can take. It’s impossible for you to know each one and when they apply, which is why tax planning is best done with a trusted financial advisor. Yet, you should be familiar with common situations that will impact your tax liability. Some examples include: 

● Capital loss deduction 

● Charitable contributions 

● Home office expenses 

● Medical expenses over a certain threshold 

● Deductions related to IRAs, 401(k)s, and other investments 

● Tax breaks for real estate investments 

3. Understanding Your Investment Choices 

Tax planning includes making choices about where you want to save and invest your money for short-term goals and for long-term retirement planning. Once again, your financial advisor will walk you through your options and discuss which types of investments are the best fit for your financial circumstances, but you should have a broad understanding of different types of investments and accounts and the way your contributions impact your tax liability. Some examples include: 

Traditional and Roth Individual Retirement Accounts (IRA) 

● 401(k)s 

● Employer-sponsored pension and retirement plans 

● Brokerage accounts 

● 529 plans, Coverdell Educational Savings Accounts (ESAs), and other ways to save for college tuition costs 

● Health Savings Accounts (HSAs) 

● Real Estate Investment Trusts (REITs) 

Key Factors of Tax Planning

  • Tax planning involves setting up strategies to reduce your taxable income in a way that is compliant with the laws of your jurisdiction.
  • Financial objectives, such as retirement and estate planning, are taken into consideration when preparing an effective tax plan.
  • It is important to analyze all available deductions and credits to maximize savings.
  • Tax planning can include deciding which business entity structure to use for your business or developing strategies for deferring taxes on investments or 529 plans.
  • Tax planning should be done throughout the year rather than waiting until filing time.

What Is Tax Optimization? 

When you have a broad understanding of the elements of tax planning such as your tax liability, deductions, and investment options, you can make informed decisions. Part of making tax planning decisions is optimization, which is the process of reducing or eliminating your tax liability through tax-efficient choices. Financial planners engage in tax optimization for their clients in many ways. You can think of tax optimization as one of those choose-your-own-adventure books. You have many choices to make about your financial future. Each choice has a different outcome, some better than others. Tax optimization is the process of making choices that lead to the best outcome for your current and future tax liability. 

Family tax planning with a consultant
Family choosing best mortgage rates

The way in which someone optimizes their taxes hinges on their individual financial circumstances and tax liability, and often includes a great deal of retirement planning. Some common tax optimization strategies include: 

1. Retirement Income Planning 

Making the best investment and tax planning decisions now require thinking about the amount of income you want when you retire​, what age you want to retire, and what 

required minimum distribution rules apply to your situation. Tax optimization when planning for retirement income means making the strategic choice to withdraw the most income when they have the lowest tax liability instead of taking money out of tax-deferred retirement accounts when their tax liability is high. 

2. Traditional IRAs vs. Roth IRAs 

Another decision that typically falls under the umbrella of tax optimization is whether to invest in a traditional IRA or a Roth IRA. This also includes converting a traditional IRA to a Roth IRA. When you contribute to a traditional IRA, you receive a tax deduction and taxes are deferred on your account until you take distributions. Conversely, you do not get a tax deduction when you make a contribution to a Roth IRA, but your account grows tax-free until distribution. 

3. Choosing the Right Investments 

Tax planning means you have to understand and make choices about investments, but optimization means choosing the investment vehicles that grow or maintain wealth while reducing your tax liability. Making tax-efficient choices helps plan for the future, but you must also factor in any gains, losses, and fees associated with your investments. Fees and expenses associated with some expenses can cancel out any tax benefits. Unfortunately, many insurance and investment products have high fees that eat up 50 percent or more of expected returns, and they often get taxed at the highest rate as ordinary income. 

Key Factors of Tax

  • Tax optimization is the process of legally reducing your tax liability by taking advantage of various deductions, credits, and other incentives offered by the government.
  • Tax optimization requires an understanding of complex tax laws, as well as up to date knowledge of changes in taxation policies.
  • Planning ahead can be beneficial when it comes to tax optimization. Strategizing how to structure investments, set up businesses, and take advantage of rebates or deductions can help you pay less taxes over time.
  • Knowing when and how to defer income or maximize charitable deductions are important elements of effective tax optimization strategies.
  • In some cases, filing multiple returns may be necessary for optimal results.

Explanation of the Differences Between Tax Planning and Tax Optimization

Tax planning and tax optimization are two strategies that have similar goals but employ different approaches to achieve them. Tax planning typically looks at specific deductions and credits in order to reduce the amount of taxes owed for the current year.
On the other hand, tax optimization takes a more comprehensive approach by looking at a wider range of factors in order to minimize your overall long-term financial risk.
The timing associated with both strategies also differs as tax planning is done at the end of or beginning of the year when preparing your taxes, whereas tax optimization is an ongoing process that requires regular monitoring and adjustments.

Key Comparisons of Tax Planning and Tax Optimization

While tax planning and tax optimization have similar goals, there are some key differences between the two strategies.
Scope: Tax planning focuses on reducing your tax liability for the current tax year, while tax optimization takes a more comprehensive approach to tax management.
Timing: Tax planning is typically done at the end of the year or at the beginning of the year when you’re preparing your tax return. Tax optimization is an ongoing process that requires regular monitoring and adjustment.
Approach: Tax planning looks at specific deductions and credits to reduce your tax bill, while tax optimization takes into account a wider range of factors to ensure you’re minimizing your overall long-term financial risk.


Work with a Wealth Advisor Who Specializes in Tax Optimization 

Financial professionals not only understand tax planning, but they have experience helping clients make choices to optimize their tax liability. One of the best tax optimization strategies that you can use to make sure you are making tax-efficient choices that save you money and grow your wealth is to work with a wealth advisor. Making these decisions without consulting a professional puts you at risk for missing unknown tax deductions. The financial advisors at Bogart Wealth have been helping clients with tax planning and optimization for more than 30 years. ​Contact us today for more information​. 

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