Why I Want To Review Your Tax Return As A Financial Planner
Taxes are an integral part of your financial life. Almost every financial decision you make will have some sort of tax implication tied to it. However, it’s always interesting to see the look on a prospect's face when I say I will need a copy of their tax return. The question that almost always follows is: do you prepare returns too? I’m quick to answer no, I’m not a tax professional, and then get a bit of a puzzled look. However, I'm a little shocked that their prior advisor hasn’t asked for it! So why am I, as a financial planner, asking for a tax return?
Tax Planning vs Tax Preparation
Many of my clients hire a CPA to prepare their taxes. This means you provide them all your W2’s, K1’s, 1099’s, charitable donations, etc. They then “crunch” the number and let you know how much you owe in taxes or what your refund amount is. That’s good, because most of us shouldn’t be doing this on our own. However, what I witness time and time again is the client seems to have an expectation that their CPA will help them with ways to minimize paying taxes. Often, the CPA has been hired to prepare a return (number crunch: here is what you owe/get as a refund) vs tax plan (here are some things we can do in advance to minimize taxes paid). So, tax planning often falls into the hands of a skilled financial planner, specifically a CFP® professional who has had training in this area.
Taxable Income
This is often the starting point of many deciding factors in a given tax year. A simple way to think of it is to add up everything you made that year minus the standard deduction or itemized deduction (whichever is greater). This is the amount you’ll owe taxes on. It serves as a base for many decisions to be made going forward. While I’m reviewing the prior year tax return, I discuss with my client what the current year will look like. In other words, should I expect much of the same or were there one-time variables that threw it off? I usually want to review the tax return as soon as possible and then circle back with my clients in Q4 to see how the year is progressing. This allows ample time to plan.
Capital Gains Rates
Now that I know taxable income, I can start looking at capital gains rates. There can be some great benefits if taxable income is low. For example, there is 0% tax on capital gains and qualified dividends up to $80,800 in income for those married filing jointly (income limit varies based on how you file). This can create some tax planning opportunities if you have a taxable account and have a low basis in your investment. As a financial planner, I can use this information to determine what to sell for this year and target to pay low to no tax. Some advisors don’t pay attention to this, but it can save clients thousands of dollars in unnecessary tax.
Long-Term Capital Loss Carryforward
Another line I like to look at is the capital loss carryforward. If you sold investments for a long-term loss (meaning you held the investment for more than 365 days) in prior years, you’re allowed to carry forward and offset future gains. If you don’t qualify for a 0% capital gains bracket, then utilizing a loss carryforward is another tactic to help eliminate current year capital gains. Even if you don’t have a gain for a specific year that you take the loss, you can utilize $3,000 per year to offset income. For example, if you sold an investment for a $10,000 loss in 2019 and had no other transactions that resulted in a gain or loss, you could use $3,000 worth of a loss in 2019 and carry forward $7,000 of the loss into 2020. If you took $7,000 worth of a gain in 2020, then you could offset it fully with the remaining $7,000 loss you carried forward from 2019. This would result in $0 capital gains tax. Knowing this helps me as a financial planner to determine what to sell, how much of it to sell, and potentially when to sell (not timing the market, but rather locking in a gain or loss).
Roth Conversion
This process involves taking pre-tax money (think regular IRA or 401(k) contributions) and converting them to Roth contributions. Remember, Roth money has taxes paid up front and then grows tax free and withdrawals are tax free in retirement (given the 5-year rule is met). By looking at your tax return, a financial planner may see an opportunity to pay a lower tax percentage on a Roth conversion now vs in the future. For example, if you're married filing jointly and have $60,000 in taxable income, perhaps we would look at converting $20,000 from pre-tax to Roth and utilize the lower tax bracket of 12%. Income situations can vary year to year, especially as one spouse enters retirement and the other still works. Opportunities like these allow you to keep more of your hard-earned money!
Medicare Premiums
While this one may not affect a ton of people, there are increased Medicare premiums for those making above certain thresholds. The more fun part of this is that your premiums in the current year are based on what you filed on your taxes two years ago! Knowing this can help plan how much income to take and when to take it, if you’re concerned about an increase in monthly premium amounts.
Standard Deduction or Itemized
To bunch or not bunch, that is the question. When I look at a tax return, I review if the standard deduction was taken or if it’s itemized. If the standard deduction is used, I like to ask clients about their deductible expenses and get a gauge of where that’s at. If it’s well under the limit, then they probably made a good choice. However, if it’s close to the limit or just over, there could be some planning work done here. An example would be a married couple itemizing deductions in the amount of $27,000 in 2021. The standard deduction amount was $25,100 for that year. State and local taxes max out at $10,000 and that was fully used. The remainder of the deductions were from charitable contributions. A strategy that can be used in this scenario is to bunch those charitable deductions together. For instance, if the couple wanted to donate $20,000 a year, they could set that aside in a savings account for 2022. Then on January 1, 2023, they could donate all $20,000 and continue their same pattern of giving throughout 2023. By doing this, it would allow them to take the standard deduction in 2022, then itemize in 2023 for $50,000 (including that year’s state and local taxes), reducing their tax bill significantly when looking at both years.
So no, I’m not a tax professional, but as a financial planner, I’m decently in tune with tax planning strategies that can help my clients. I’m still relying on the tax pro to prep the return and clear certain situations with them. We always want to rely on experts, but as a financial planner for my clients, I know their full picture and can begin looking for and setting up the strategies to target a lower tax bill.
If your financial advisor isn’t looking at your tax returns and doing this kind of work, I’d love the opportunity to discuss your situation with you. Feel free to schedule an appointment by clicking the button at the top of the page!
Please note, this communication is for informational purposes and is not intended as tax advice.