Taxation is merely one piece of the financial planning puzzle, but it is second only to investments as the topic that most individuals want to control during the financial planning process.
Have you ever met anyone who is glad to pay as much tax as possible? New York State Appellate Judge Learned Hand even stated in one of his oft-quoted decisions in the early 1900s that it is our constitutional right to pay as little tax as legally permissible. Yet without professional guidance through the maze we currently call our Internal Revenue Tax Code, paying as little tax as legally possible is an elusive goal.
In the broader world of financial planning, there is little doubt that the CPA financial planner may have an edge over non-CPAs when it comes to income tax planning. For many CPAs, annual tax planning is a ritual for their clients looking to follow Justice Hand's mantra. But how do you integrate all of the complicated pieces of a client's tax situation for their long-term benefit? With issues like the Alternative Minimum Tax, capital gains, business gains or losses, Social Security and the guestimate about future tax rates, good income tax planning is dynamic and maybe even intergenerational.
TAKE THE NATURAL STEP
It's easy to see when a client has not had the benefit of good income tax planning. You may see poor coordination with the management of a portfolio, missed Roth conversion opportunities, or huge refunds or taxes due upon filing.
The most significant advantage that a tax practice brings to a financial planning relationship is the regularity of service. At least annually, the tax preparer is forced to take a big-picture look at the client's personal financial issues in order to prepare the return. The preparer becomes familiar with all items of income and expense at the time of preparation. Leading that tax prep engagement into one for income tax planning for subsequent years and the integration of all matters financial is a natural step; yet too few tax professionals take this step.
A CPA financial planner should start with income planning. During your clients' prime working years, you may be limited in ways to materially cut the income tax bill. But taking advantage of every tool in your arsenal to mitigate, reduce or defer taxation for your high-income clients will have benefits that may compound over the years to improve their wealth. First you need to understand your client's sources of income to plan accordingly.
Income planning takes on a new meaning when your client is beyond their prime earning years and easing into retirement. This is especially true if your client is in the time period before required minimum distributions start and after the large earning years have passed. All too often I see early retirees thrilled with the fact that they are in the 15 percent tax bracket. I look at that as a missed opportunity to pay the lowest amount of tax legally possible.
When your client is in such a low tax bracket, why weren't there any capital gains triggered? Wouldn't it be helpful to create these gains at a time when the tax will be low to non-existent? I find this same possibility for the client with large capital losses to carry forward.
These clients are inherently reluctant to create gains, and need a good tax and financial planner to let them know about the carried losses and how that may help them to diversify their portfolio and mitigate their eventual income tax bill from the sale of assets for a gain.
If the CPA is not directly involved in the oversight of the portfolio management, this is your chance to become more involved. You should ask for copies of each monthly statement and pay attention to matters like realized and unrealized gains and losses.
As the year winds down, insist on a face-to-face meeting to reveal what you've found, along with your recommendations to tame the tax consequences. I think the days of the CPA blaming the broker or investment advisor for tax surprises at the end of the year are gone. You and I both know that it may have been the advisor's actions that caused an inefficient tax situation. But we also know that you could have reached out for an interim tax planning meeting to discover and address possible courses of action.
TIMING AND TAXES
Required minimum distributions, or RMDs, are another issue that typically drive clients crazy. How many times have you heard this: "Why do I have to take money out of my retirement plans and why can they dictate that I do so?" Of course, we know the simple answer here, but why don't more CPAs pro-actively anticipate RMDs and do whatever is possible to mitigate their consequences?
One possible solution is to start taking distributions before the RMD date arrives. To the extent that your client has lower taxable income in the years prior to RMD-land, why not start taking qualified money sooner than the RMD date? Of course, we CPAs are hardwired to think that deferral for as long as possible is most accretive to wealth building, but only if all other things remain consistent. If you can get qualified money out while in a 15 or 25 percent tax bracket, isn't that better than paying 40 percent once RMDs kick in?
Another possibility is a Roth conversion. I've had many wealthy clients do small Roth conversions over the years. The benefit here can be to reduce future RMDs, eat up low tax brackets that may go to waste, and create a pile of tax-free money through to the next generation. This strategy works best with a few classes of taxpayers, all of which have time on their side. For those who have other non-qualified wealth to support their lifestyle and don't want or need their qualified money for support, a Roth conversion can have a double tax benefit. The first is that the tax paid in the course of a Roth conversion will reduce the client's overall estate, and reduce any death taxes that may become due. This may also have the benefit of providing intergenerational income tax planning. If your client has high-wage-earning children, they will appreciate the benefit of inheriting Roth accounts, rather than traditional qualified assets.
To mitigate the tax associated with a large Roth conversion, your client may consider utilizing charitable contributions or investments in tax-favored vehicles like oil and gas. Of course, the AMT may be an issue, so make sure that you have thoughtful forecasts before springing into action.
The CPA financial planner may also consider suggesting that their client invest in such a way as to generate tax-friendly income. One may be through owning tax-free municipal securities. This isn't the right solution for all, as municipal securities may lose value if interest rates rise. With the low interest rate environment lasting longer than many had anticipated, the yield from these securities may not generate the income needed.
Conversely, make sure that your clients who have purchased tax-free interest-generating holdings are in a tax bracket high enough to benefit from the generally lower yield provided by such holdings. A taxable equivalency calculation may be prudent when choosing between taxable or tax-free investments.
The use of immediate fixed annuities is another tool that can reduce your client's tax bill. These immediate annuities will take advantage of the exclusion ration provisions in the Tax Code, and materially reduce the taxability of the income stream.
On the deduction side of tax planning, there may be a few opportunities worth re-examining with your client. Charitable contributions are one such area. The CPA financial planner is frequently better equipped to forecast the consequences of large contributions and the final regular or AMT bill.
Using appreciated property or securities is another frequently overlooked area, and one that is right in the CPA's wheelhouse. The CPA who is paying attention to the client's lifestyle, gifting patterns and assets is best suited to assist with the implementation of gifting appreciated securities.
Qualified plans may have a role here also. Clients with outside income from director's fees, speaking or consulting may be eligible to establish a retirement plan. A defined-benefit plan, for example, may help shelter a significant portion of this personal income.
The last tax that a CPA can help to design a mitigation strategy around is the estate tax. While many of your clients may escape federal taxation with the $5.3 million exclusion, the states frequently have far lower exemption amounts. The new federal exemption has blinded many tax payers to the possible shrinkage caused by state death taxes.
All financial planners should be vigilant with planning to reduce death taxes. It is one of the few taxes that are regularly paid where simple planning may have reduced or eliminated the tax.
There are many simple ways to ascertain whether a client is set up to minimize death taxes. First, ask when their estate planning documents were drafted. Their age alone may signal that there could be a problem. The second is based on the title of their assets. Any client who has paid an estate tax attorney to help should probably own assets in their trusts to perfect the proper utilization of the federal and state credits.
Joint ownership of assets doesn't mean that the estate is a mess and a target for future taxation, but it is a signal that the estate plan may not be fully implemented. Just think about all of the joint 1099s you saw during tax season. That's a lot of estate plans that may need help.
John P. Napolitano, CFP, CPA, is CEO of U. S. Wealth Management in Braintree, Mass. Reach him at (781) 849-9200.
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