Given the highly commoditized nature of tax preparation, finding ways to add value is key to growing a practice of high-net-worth tax clients. Helping clients maximize their after-tax cash flow and preserve wealth is critical for many clients at or near retirement. A tax adviser can help a client smooth out the high-income-tax peaks and the corresponding lower-tax-bracket years with an effective bracket-management strategy.
Currently, there are seven tax brackets, but this number ignores the alternative minimum tax (AMT), net investment income tax, Medicare surtax, and long-term capital gain rates. Some expect that tax code and tax bracket simplification will occur, yet even if it does, bracket management will remain a key tool to help clients in retirement, when income is relatively fixed. It is important for practitioners to keep a close eye on how these strategies could be affected by any potential tax reforms.
The initial best step for any practitioner is to gain a complete understanding of a client's full financial situation, whether by providing a financial plan or reviewing one prepared by another practitioner. These financial plans often outline a client's goals, estimated budget, steps that need to be taken to reach the desired outcome in the plan, and factors out of the client's control that could impact the results. This will allow for the creation of both short-term and long-term tax planning strategies.
Pull from after-tax asset buckets: It seems like a straightforward idea to withdraw funds from investment vehicles that have minimal to no tax impact. However, it is easy for clients or other tax advisers to be unaware of the client's big picture, which could lead to unintended tax consequences if cash is withdrawn from certain assets. This can vary from year to year, so it is important to maintain full knowledge of a client's various assets.
Harvesting capital losses: If a client has capital gains that are being taxed in the highest bracket and are subject to the net investment income tax, harvesting some losses could help lower the client's tax bill. The tax adviser should always recommend that the client speak with an investment adviser about the implications. Also, the tax adviser should ask whether any investments in mutual funds are expected to make capital gain distributions. If the gain on a sale of shares of the mutual fund would be smaller than the estimated capital gain distribution, or the sale of the mutual fund shares would generate a loss, it may be appropriate to sell the mutual fund shares before the capital gains are distributed. Most funds' capital gains distributions occur in December and can cause unanticipated tax consequences.
Deferral of income: One of the easiest ways to legitimately defer income is to delay a distribution from an individual retirement account (IRA) or a Sec. 401(k) account. The rules for required minimum distributions (RMDs) should be reviewed when looking at the following strategies:
- In the year that a client turns 70½, would it be beneficial to delay the first RMD until the following calendar year by the deadline of April 1?
- If the client has charitable intent, would it be more efficient to make a qualified charitable distribution from an IRA rather than taking the IRA distribution and making a separate cash donation of monthly withdrawals from the retirement asset?
Donating long-term appreciated securities: Clients can receive the benefit of the full deduction for the fair market value of publicly traded stock when there is little basis in the shares. This is a highly tax-efficient means for clients to achieve their charitable goals.
Accelerate deductible tax payments: Concentrating deductions in a high-income year is an advantageous strategy for reducing income taxes. Real estate taxes are often an easy expense to accelerate. Consider paying in full during high-income years and delaying the second or third payments to the following year if income is unexpectedly low. This will maximize the client's deduction during the years when it is needed most. Also evaluate the potential benefit of paying estimated state income taxes before the end of the calendar year. Matching the state income taxes with the higher-income period, instead of waiting until the fourth quarter estimate or extension due date, can give the deduction a larger overall tax impact, assuming the AMT does not come into play.
Concentrate charitable giving: Giving in December versus January can make a significant difference to a client whose income varies from year to year. Be sure to remind clients that generally a contribution is considered made at the time of its unconditional delivery, which, if a check is mailed, is the time of mailing. A properly endorsed stock certificate is generally considered delivered on the date of mailing or other delivery to the charity or to the charity's agent. For gifts of greater than $250, a contemporaneous written acknowledgment from the donee is necessary.
Beyond thinking about the cash needs for the current year, consider your client's asset class buckets. In a low-income year it can be helpful to fill up the lower buckets with pretax dollars or other income.
Roth conversion: A well-timed Roth IRA conversion is a great way to increase a client's nontaxable bucket, especially if the client has a large pretax retirement account and limited other assets. After the conversion, a client must wait five years from the first day of the tax year of the conversion to withdraw the funds tax-free. If this time frame fits into the client's financial plan, a Roth conversion can be advantageous.
Traditional IRA or 401(k) withdrawal: In situations when clients know they will need funds from their retirement accounts within five years, a distribution of cash to set aside during a low-income year can allow them to take advantage of lower tax brackets and improve their overall tax situation.
Example: A client will need $100,000 for a down payment on a retirement housing facility in three years. Federal income taxes can be reduced if the client falls into the 15% bracket for the first two years and then is expected to jump to the 28% bracket during the third year (this example ignores state taxes). If distributions were taken to net $20,000 in each of the first two years and $60,000 in the third year, the grossed-up distribution needed would be about $130,392 ([$20,000 ÷ 0.85 × 2] + [60,000 ÷ 0.72]). If the marginal rate on the $100,000 distribution all in the third year is 28%, the overall grossed-up figure would need to be $138,889. The tax savings due to bracket management is almost $8,500, ignoring the time value of money.
Harvesting long-term capital gain: In addition to the lower tax brackets allotted to long-term capital gains of 15% or 20%, there is the elusive 0% rate. For clients with regular income taxed at the 10% or 15% rate, the 0% bracket is applied to long-term capital gains. Without strategic year-end tax planning, this opportunity could easily be missed.
Defer deductions to larger-income years: Evaluate any expenses that can be deferred to higher-income years. The same items that can be pushed into a high-tax year can also be pushed out of a low-tax year.
Practical use of strategies
How useful are these strategies if clients never discuss their future expected spending needs? It is easy to find lists of tax planning ideas, and some clients might even bring these ideas to their tax advisers, but consistently providing tax planning can be tricky if the accountant is only viewed as a tax preparer. Sometimes clients realize the importance of planning after making a misstep that results in a surprisingly high tax bill.
Where a tax adviser can show his or her true value is in being proactive and asking the right questions when given the chance. Here are some questions that should be asked of clients who are preparing for retirement:
- Do you have a financial plan that addresses your transition to retirement?
- Do you have a tax-efficient withdrawal strategy for achieving your retirement spending goals?
- Do you expect significant expenses within the next three to five years?
- Would you feel comfortable if I worked with your investment or financial adviser when you pull from accounts for cash flow needs and to request information near year end?
- Would you consider paying a little bit more tax in a particular year if, ultimately, you would pay less over your lifetime?
The last question hints at the fact that getting a client's tax bill to zero is not always the best strategy when looking at a long-term tax plan. Minimizing the tax bill for a single year is not the goal—long-term and lifelong planning allows for the greatest positive financial impact.
Michael D. Koppel is a retired partner with Gray, Gray & Gray LLP in Canton, Mass.
For additional information about these items, contact Mr. Koppel at 781-407-0300 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with CPAmerica International.