There’s a common misconception that financial advisors handle everything related to a client’s finances, including their taxes. In reality, this is rarely the case. To understand what financial advisors can (and can’t) help with, it’s essential to understand the difference between tax preparation and tax planning.

Who handles tax preparation?

The term “prepare” can be misleading here, because tax preparation is actually a recap. You’re preparing tax returns, but you’re essentially looking at things that have already happened in the previous period (like a calendar year), documenting those events with the IRS, and paying whatever is owed.

This exercise tends to be document-driven (it requires gathering numerous documents, such as Form W-2s, 1099s, K-1s, etc.) and generally speaking, accountants are the professionals that prepare tax returns. You might work with a certified public accountant (CPA), possibly with a tax specialization.

Some financial advisors have this expertise, but it’s not necessarily aligned with the primary work we do—financial planning, investment management, retirement planning, and so on.

A good financial advisor, however, is aware of the tax ramifications of different financial decisions. They can work closely with your accountant and other financial professionals. And they can help you engage in tax planning.

How is tax planning different?

While preparing tax returns involves recapping past actions, tax planning looks for opportunities to reduce the taxes you’ll owe in the future. The goal is often to reduce your annual tax obligation. Sometimes, it’s to reduce the amount you pay over your lifetime. Other times, it’s both.

Financial advisors can work with accountants, tax attorneys, and other specialists to help you identify and seize these opportunities. Here are a few of the ways a financial advisor can help with tax planning.

• Tax diversification. Where do your investments live? If all of your investments are in a pre-tax retirement account, like a 401(k), you don’t have much tax diversification—all of your income in retirement will be subject to tax, and you likely won’t be able to access it without penalty before you turn 59½ . However, if you have money invested in a 401(k), a Roth IRA, and a brokerage account, you have a bit more diversification from a tax perspective. Advisors can go a layer deeper here and make sure investments live in the most strategic place. For instance: You don’t pay federal income tax on interest paid by municipal bonds (munis). If you keep munis in a pre-tax retirement account, you will end up adding to your tax bill (as that interest will be taxed when it’s distributed as income). Finding the right tax location for your investments is another component of tax diversification.

• Roth conversions. If an advisor notices you don’t have any tax diversity, they may suggest opening a Roth account. If you don’t qualify for direct contributions to a Roth IRA, the advisor may be able to help you arrange a backdoor Roth contribution via a Roth conversion. The details of this can be complicated; part of tax planning involves identifying whether (and when) this type of conversion might make sense.

• Capital gains and tax-loss harvesting. The IRS allows individuals to use capital losses to offset capital gains. It’s possible to strategically sell certain underperforming investments and use any capital losses to offset capital gains. This must be done strategically to avoid violating various IRS rules, so it’s almost always beneficial to work with an investment professional.

• Business structure. For anyone running a business, financial advisors may be able to spot opportunities to revise your business structure in a way that reduces your tax liability or creates new tax-advantaged opportunities for you to save for retirement. These types of decisions are best made in conjunction with an accountant and an attorney.

• Income planning in retirement. How your income is taxed in retirement will vary based on its source. A financial advisor can help you include tax liability amongst the myriad other factors that impact income planning in retirement. For instance, you may not want to withdraw funds from an investment account during a market drawdown; if you prioritize other income sources, will it impact your tax bill now and in the future? Is it better to start withdrawing from your Roth account or your pre-tax 401(k)? What about Social Security? A financial advisor can help you get a handle on the moving pieces, while taking tax liability into account.

While most financial advisors aren’t CPAs, they can still do a lot to help you manage your taxes. Most of that work, however, doesn’t happen in the lead up to April 15.

If, as you work to prepare your taxes each spring, or examine your returns after they’re filed, you find yourself wondering what you could be doing better—we may be able to help. Reach out today to schedule a call with one of our advisors.