lients respect and appreciate you when you can help them navigate the tax code. Many tax preparers are great at telling clients the consequences of actions, but frequently the financial planner is the one who will look down the road over several years to identify how strategies can be utilized to positively impact a client’s future tax bill.
You just completed an analysis and projection of the tax consequences for potential portfolio moves. Another example of how you may be involved in tax planning is planning to shift income because a client is going to be supporting a parent in the near future. Another example is planning to shift income for just one year to create a lower taxable income so you can transition Series EE bonds into a 529 plan. This is a good strategy to use when you believe the client will soon be phased out of that option. This type of integrated planning can make a big difference for clients. You won’t be doing any major shifts like that for Jim and Anne, but you do need to understand their situation and identify potential opportunities or concerns that you will want to track as your relationship progresses from this first, full-blown financial plan to ongoing planning in later years.
Tax Projection for This Year
The Dowlers received a tax projection from their accountant for this next year that they believe is accurate. They have already submitted their tax return for this year and the refund is entered into the cash flow changes worksheet as funds available for you to use. Examine this projection so you can evaluate the consequences of potential recommendations.
C
Table 14: Income Tax Projection
Income Tax Calculations
Wages $137,812
Interest $286
Dividends $4,834
Short-term capital gains $550
Total Income for tax purposes (line 22 on Form 1040) $143,482
Adjustments to income $0
AGI $143,482
Itemized Deduction Calculations:
Medical over 10% $0
State taxes ($5,227)
Real estate taxes ($2,352)
Mortgage interest ($12,228)
Misc. deductions over 2% $0
Charitable contributions ($4,396)
Total Itemized Deductions ($24,203)
Calculating Taxable Income
Income after itemized deductions (line 41) $119,279
Subtract exemptions (3 x $4,000) ($12,000)
Taxable income after subtracting exemptions $107,279
Tax
Amount over $74,901 but under next category. This
is amount to be taxed at 25% $32,378
Alternative Minimum Tax Add-backs
less medical (too low—under 10%)
less state taxes $5,227
less real estate taxes $2,352
Total of add-backs for AMT $7,579
AMT Tax Calculation
Start with income after deductions but before
personal exemptions (line 41 on Form 1040) $119,279
Add back adjustments $7,579
AMTI $126,858
subtract AMT exemption ($83,400)
$43,458
AMT tax multiply by rate 26% = $11,299
Compare to regular tax $18,490
if greater = difference, if lower 0 $0
Child Tax Credit $1,000 per child potential
Start with AGI $143,482
Subtract phaseout start ($110,000)
$33,482
ROUND UP $34,000
Multiply by 5% (.05) $1,700
Subtract from credit ($1,000)
Child tax credit Not Eligible
Other taxes N.A.
Other credits N.A.
Total Due $18,490
Taxes withheld - Jim ($16,672)
Taxes withheld - Anne ($7,360)
Total withheld ($24,032)
Amount Due $18,490
Projected Refund for this year ($5,542)
Colorado State Tax 4.63%
Start with Taxable Income $107,279
Add back state taxes $5,227
Colorado taxable income $112,506
*.0463
Projected State Tax $5,209
Projected State Refund $18
Table 15: Tax Rates
Federal State Combined
Marginal 25.00% 4.63% 29.63%
Effective 12.95% 3.63% 16.58%
Identifying Opportunities or Concerns
The Dowlers have asked for any advice that you may have on lowering their taxes. Now you need to consider strategies for achieving their goals while utilizing tax benefits. The following exercises will lead you through analyzing possible tax-saving strategies.
There are many income limits that apply to the ability to utilize tax credits or savings vehicles like IRAs and Roth IRAs. Sometimes, your actions such as rebalancing a portfolio can increase a client’s AGI, causing them to not qualify for certain deductions or credits. Thus, it is important to understand where a client is situated in relation to AGI limitations and other brackets. Other times, increasing contributions to qualified plans or flex plans can reduce the client’s AGI, making them eligible for certain strategies or credits. Examine the chart below that shows the Dowlers’ AGI compared to various tax phaseouts. Identify the potential concerns or opportunities that could realistically apply to their ability to participate in the following accounts or strategies. For example, if you triggered more than $30,000 in income in the current year, they would then be subject to the phaseout of the AMT exemption amount, possibly creating the need to run the AMT calculation.
Table 16: Tax Concerns and Opportunities Assessment Items Based on AGI or Modified AGI
Client AGI: $143,482
to Trigger Concern or Opportunity Personal
$158,900 AMTI ($16,624) Concern—track gains or increase in income to not trigger AMT
EE Bonds $115,750–145,750 ($27,732) Opportunity—if reduce income could convert Series EE to 529 plan.
Most likely, exclusion will be phased out in future so best not to utilize Series EE bonds for education Coverdell $190,000–$220,000 $46,518 Opportunity—eligible to utilize Lifetime
Learning Credit
$118,000–$128,000 ($25,482) N/A at this time—phased out
American
$130,000–$160,000 ($13,482) N/A at this time but Concern— track gains or increase in income
Child Tax Credit (one child)
$110,000–$130,000 ($13,482) Opportunity—if income reduced by more than $13,500 would qualify for some benefit
Traditional IRA (both active)
$98,000–$118,000 ($25,482) N/A at this time phased out—would have to reduce income by $26,000 at least
Roth IRA $183,000–$193,000 $39,518 Opportunity—Eligible to utilize
Plan Development #17
Write your list of realistic potential concerns and opportunities that you will want to keep in mind during your planning based on the clients’ fact pattern. You may wish to include comments on some of these in your explanation of tax planning recommendations or as part of an advantage when addressing qualified plan contributions in the retirement section. For example, they are eligible for Roth IRAs at this time but not traditional IRAs. That will probably impact potential recommendations. Additionally, if you were able to reduce their income by
$15,000 through 401(k) contributions or flex plans, the client may gain back some or all of the child tax credit.
Flexible Spending Accounts
One obvious tax saving strategy would be utilization of their flexible spending account (commonly referred to as a “flex plan”). Jim and Anne asked for your input and help in understanding flexible spending accounts.
Their average expenses for medical, dental, and eye care expenses out of pocket is around $1,300 each year, and that has been consistent for the last few years.
Both Anne and Jim have access to flexible spending plans. Both plans also allow the client to roll $500 of expenses into the next plan year. Answer these questions related to flexible spending plans.
Plan Development #18
Write your recommendation about what they should contribute to a flexible spending account and what will it save them in taxes?
(Remember federal + state + FICA.) The tax code changed in 2013 to impact the “use it or lose it” rules, so make sure you are current with these rules! Be specific about the rules of flex plans in your advantages and disadvantages. You may want to explore what items are deductible in addition to those mentioned above.
Transfer the tax savings results to the cash flow changes tracking document but remember that they are already incorporating the cost of medical expenses in their budget so you don’t need to show the $1,300.
If you have them contribute MORE than $1,300, you would show that as additional deduction on their cash flow.
Appreciated Stock Gifting
Another available strategy is gifting of long-term appreciated stock versus cash to consistently supported charities. One of the common misperceptions about this strategy is that it is limited to appreciated equities that you want to sell. The client can take the cash they were going to donate and rebuy the same stock! The benefit is that it now has a stepped-up basis. You have given away the capital gains but retained the exact same position.
There are no wash rules related to gifted stock. Additionally, the full value of the gifted stock can be deducted as a charitable donation. Be aware that short-term gain stock may be donated but the charitable deduction is limited to the basis.
This strategy doesn’t work for the small donations that clients make, but Jim and Anne gift $4,000 to one specific charity each year. They have the small-cap stock fund of $40,467 in which 25.87% is long-term gain. You are selling part of it in order to balance out their portfolio. Additionally, the specific fund has been underperforming and has a high fee structure. You and your investment team agree it would be in the Dowlers’ best interest to eliminate this investment, and
the clients are willing to sell it over time but are concerned about the taxes. You are considering recommending they gift the stock and use the cash they normally donate to the charity to rebuy the same amount in a new investment.
The Dowlers have been making and receiving the tax deduction for their charitable contributions. What you are going to calculate is the tax savings for donating the stock versus selling the investment outright over time. Assume that they will then take the cash that was being donated to charity and purchase a new or the same investment so that their asset base remains the same. This strategy works especially well for high net worth clients who consistently gift. Frequently they are willing to bundle gifts into one year to assist in portfolio reallocation.
This strategy is not appropriate for individuals who have not accumulated the wealth, life insurance, and disability protection that they need because charitable giving would be eliminated in case of financial crisis.
Plan Development #19
Calculate what the tax savings would be if Jim and Anne gifted $4,000 of appreciated small-cap, long-term gain stock this year rather than selling it, and then write your recommendation.
Write your recommendation describing the strategy of gifting appreciated stock. Include an explanation of the tax savings it would create. You can use the first year ONLY to offset a portion of the taxes on the planned sale to bring the portfolio in line unless you are splitting the sale over two years.
However, in future years, the cost would not be there if you didn’t sell the stock. You would have to show the tax and then the tax offset from gifting so it will NOT create additional cash flow. You can show the cost of selling the stock and then show the tax offset from gifting in your cash flow or you can just explain it in your executive summary. Not all of your recommendations will have cash flow impact.