This time of year is busy. We are deep into the weeds of end-of-year tax planning for clients. Once you get to know a client’s situation, this process becomes easier, as many of the strategies become like muscle memory, adjusted for conditions. It’s kind of like adjusting your golf stance for the wind.
However, when a prospective client comes to us, we do a deep dive on their tax return for a few reasons: Every return tells a story and gives us a bit more insight into who they are and what’s important to them. Someone who gave last year to Planned Parenthood may come from a different background than someone who has made large donations to the NRA Foundation.
We are also looking for inefficiencies. Where are there little tweaks that could reduce the prospective client’s taxes?
All of these “inefficiencies” are circumstantial, and there can be reasons to justify each one. That said, here are the tax triggers we look for that lead us to dig a little deeper.
1. Inefficient interest and dividend income
Interest income is reported on Line 2 of IRS Form 1040. Dividend income is on Line 3. All else being equal, you’d rather have tax-exempt income than taxable income. You’d rather have qualified dividends than ordinary dividends.
These classifications of taxation are determined by the underlying investments in non-retirement accounts. You should not let “the tax tail wag the investment dog,” but when the proportions get out of whack, we dig deeper.
2. IRA distributions before RMD age
Often the most efficient distribution sequence in retirement is: cash first, taxable investments next, then Social Security. RMD rules force those distributions from pre-tax accounts starting at age 73 (rising to age 75 beginning in 2033). These are often a necessary evil for affluent retirees, and thus, you wouldn’t expect to see them on a return prior to the age at which RMDs kick in.
Roth conversions will show up as IRA distributions, so this, too, requires digging.
3. Non-reporting of QCDs
For those 70½ or older, giving money to charity from an IRA through a qualified charitable contribution is very tax-efficient. The downside is that custodians do not track this for you. Your QCDs get lumped together with other distributions on your 1099. So, if someone says they gave to charity from an IRA, but it’s not reflected on Line 4 of the 1040, an amended return may be in order.
4. Large Social Security benefits before age 70
Prior to 2016, there were several creative Social Security claiming strategies for those who are, or who were once, married. Today, there is not as much opportunity. However, with our affluent clients, we often employ the “higher delays, lower gets a raise” strategy. This means that the spouse with a lower benefit would turn on their Social Security when they retire. The higher earner would wait until age 70, to maximize delayed retirement credits. Therefore, if I see a big benefit before 70, the retirement income strategy may be flawed.
You can access a free version of our financial planning software to find the “optimal solution” when considering the rest of your goals and your assets.
5. Significant capital gains without a significant event
Your Schedule D, which reports capital gains and losses, usually tells a happy or sad story. The retirement downsize that saw your forever home sell for seven figures. The Peloton stock bet that didn’t quite play out as you thought it would as you pedaled along in your basement.
Where issues exist is when there are significant gains that don’t reflect anything you did. These are referred to as “phantom gains” and are typically a function of a mutual fund manager selling the stock within your portfolio. That gain passes along to you, even if you haven’t made a cash sale or received a distribution.
6. Significant capital gains AND charitable intent
What really grinds my gears is when I see significant gains on Schedule D in the same year the client made cash charitable contributions. You can donate shares of whatever you sold for a gain and avoid paying those capital gains taxes. It just takes someone telling you and, often, doing it for you.
7. Underpayment penalties (not large refunds)
Underpayment penalties are avoidable. Most accountants will base your quarterly estimates on a “safe harbor” amount. You can avoid underpayment penalties by paying 110% of your tax obligation from last year. You should understand that this does not mean that this is what you will owe; it simply means you won’t pay unnecessary penalties.
8. Significant Schedule C income
If you’re retired and well off, your Schedule C income is probably a choice, not a necessary income stream. Following that logic, you’d probably rather defer the taxes than pay in that year. If you’re self-employed, you should be able to defer a large chunk of that consulting income by setting up a SEP IRA, solo 401(k) or other retirement plan for yourself.
9. Losses on Schedule E from real estate
It is common to show losses from rental properties on a Schedule E, especially early on. When you first buy a property, you have depreciation, high mortgage interest deductions, improvements, etc., all of which will reduce your rental income. However, by the time you retire, that property may be fully depreciated. If you’re still showing losses, it may just not be a good investment.
10. Unnecessary K-1s
K-1s may be how you accrued your wealth through a business partnership. I extend my tax return every year because of them (these forms are notorious for arriving late). I’m building. However, once you’re retired, they may not represent active ownership in a business. More likely they represent private investments that sounded great when you bought in. Let’s hope they were. But if they didn’t do what you expected and they complicate your returns every year, it may be time to reconsider.
This is by no means a comprehensive list, but since most financial advisers don’t look at your tax return at all, and most CPAs don’t do forward-looking planning, this is a big step in the right direction.
I also want to be clear that this is not a list of “10 Opportunities on a Retiree’s Tax Return.” That would include things like low-tax years to maximize income recognition through capital gains and Roth conversions. Or high years to maximize deferrals. Those are different articles.
