Financial planning dialogues around Form 1040

By Robert A. Westley, CPA/PFS

Editor: Theodore J. Sarenski, CPA/PFS

The new tax act, P.L. 115-97, known as the Tax Cuts and Jobs Act (TCJA), includes wide-ranging, albeit mostly temporary, changes to the individual income and transfer tax regime. As a result, given the integrated nature of tax laws and personal financial planning, many strategies that were once beneficial may no longer be worthwhile in the new tax environment, and new strategies may be needed. Since individuals commonly have the broad financial planning goal of maximizing their after-tax wealth, tax advisers must give thought to their clients' strategies and tactics under the TCJA.

An individual's tax return is a natural starting point to evaluate the impact of changing tax laws on a financial plan. Therefore, CPAs and tax advisers are at the forefront of encouraging individuals to fine-tune their financial plans by opening a dialogue about their tax return and raising relevant questions. CPAs have a unique opportunity to add value to their tax compliance engagements by communicating the TCJA's impact on clients and helping them navigate the issues it raises in their financial plan. Proactively identifying pitfalls and uncovering opportunities are at the core of this practice.

This column outlines several financial planning concepts, recognizable from an individual tax return, that the TCJA may have disrupted or introduced in a broad range of circumstances.

Tax-efficient investment planning

Taxes have a significant impact on investment returns and the management of an investment portfolio. Since after-tax performance is what matters to investors, a change in marginal tax rates calls for an update to a portfolio's projections and analytics.

Investment advisers and portfolio managers generally use marginal tax rates when evaluating investment trade-offs and planning decisions. Investment professionals may assume that a client with a large asset base or high cash flow is subject to the highest marginal income tax rate. However, they might not consider changing tax rates and brackets or the tax characteristics of different types of cash flows and investment accounts. CPA financial planners can add value to their clients' investment planning by ensuring any tax assumptions underlying the portfolio analyses are accurate. As CPAs begin to prepare projections and pro forma tax returns for the 2018 tax year and beyond, they should pay close attention to changes in anticipated marginal income tax rates.

Tax-equivalent yield

When reviewing a tax return with a client, the CPA should note lines 8a and 8b of the 2017 Form 1040, U.S. Individual Income Tax Return, on which are entered interest income from, respectively, taxable and tax-exempt bonds and other sources. Since the absolute yields of the two types of bonds are not directly comparable, investors need to consider tax-equivalent yields when evaluating the after-tax return on their fixed-income portfolio. The tax-equivalent yield is calculated by dividing the tax-exempt yield by the difference of one minus the investor's marginal income tax rate.

Example 1: A married couple filing jointly with $475,000 of taxable income were formerly in the 39.6% federal income tax bracket but are in the 35% bracket in 2018. The lower tax rate may alter the efficacy of their fixed-income investments. A high-grade 10-year municipal bond may have an average yield of approximately 2.5%, while a high-grade 10-year corporate bond may have an average yield of about 4%. The yield on the federally tax-exempt municipal bond equates to a 4.14% taxable yield for an investor in the 39.6% tax bracket, but the tax-equivalent yield falls to 3.85% for an investor in the 35% tax bracket. Consequently, under a new, lower income tax bracket, the investor's municipal bond portfolio may no longer be the ideal investment choice.

Alternatively, the CPA may encounter an individual in the highest marginal tax bracket reporting only taxable interest income, when tax-exempt investments may offer a higher after-tax yield. Also, consider the real estate professional who has sizable positive cash flows but tax losses due to noncash deductions for depreciation. The portfolio manager may very well assume this individual is in the highest income tax bracket, even though the tax return reports minimal or even no taxable income.

Capital loss carryforwards

A review of line 13, "Capital gain or (loss)," of the 2017 Form 1040 shows any net capital losses up to $3,000, with the balance carrying forward and detailed on Schedule D, Capital Gains and Losses. This presents an opportunity to ask the client if a coordinated strategy is in place to harvest gains to absorb the losses.

0% capital gains bracket

The preferential rates for long-term capital gains and qualified dividends of 0%, 15%, and 20% continue to apply under the TCJA using essentially the prior thresholds. As a result, preferential capital gains and qualified dividend rates no longer line up neatly with the ordinary income tax brackets; one must refer to the statutory "maximum zero rate amount" prescribed under Sec. 1(j)(5)(B)(i). CPAs should be sure to take note of the 0% tax rate on capital gains that generally applies in 2018 to married individuals filing jointly with taxable income up to $77,200 and single individuals with taxable income up to $38,600. The client may have a year with uncharacteristically low taxable income, and this is an excellent opportunity for the CPA to add value by notifying the client that gains can be harvested, to a certain extent, free of capital gains taxes.

An important caveat to keep in mind is that tax considerations, while significant for taxable investors, may not always be the decisive factor in selecting optimal investment strategies. However, detail-oriented CPAs can support their clients' investment planning by bringing changes in tax rates and tax characteristics to their attention.

Estate/wealth transfer planning

The TCJA increased the federal estate, gift, and generation-skipping transfer (GST) tax exclusions to $10,000,000 per person ($11,180,000 for 2018, indexed for inflation) beginning Jan. 1, 2018. This exclusion amount is scheduled to sunset effective Jan. 1, 2026, with reversion to the prior federal law. Estate planning under the new tax law varies considerably with each client's facts and circumstances. CPAs preparing Form 1040 have enough insight into their clients' family and financial circumstances to start a dialogue on their estate planning needs.

Reviewing a client's filing status and dependents, lines 1 through 6 of the 2017 Form 1040, provides an excellent segue into a conversation about meeting the basic estate planning needs and goals of each family member. It is imperative to confirm that clients have the appropriate documents in place so that their estate can transition as efficiently as possible at their death or incapacity. Discuss the importance of each family member's having an up-to-date will, revocable trust, durable financial power of attorney, and health care proxy.

Testamentary estate planning: Review formula clauses and state estate taxes

The doubling of the estate tax exclusion amount under the TCJA calls for CPAs and tax advisers to encourage their clients to review the dispositive provisions in their estate plans. From the tax return process, CPAs have a good understanding of a client's net worth, including assets, liabilities, titling, and tax basis. In addition, CPAs have a long-standing relationship with some clients and may be able to facilitate difficult conversations (i.e., discussions of mortality and planning for it) with any outside advisers. Therefore, CPAs can offer informed advice, ensuring the existing estate plan appropriately meets the client's needs and objectives.

Before reviewing the plan, be sure to understand the relationship of a client's net worth to the newly increased exclusion amounts. For married couples, a common plan formerly was to fund a credit shelter trust at the first death of up to the federal estate tax exclusion amount, with the residuary assets qualifying for the marital deduction by passing either outright to, or in trust for, the benefit of the surviving spouse. Under the TCJA, the credit shelter trust formula may result in a much higher funding amount.

During the tax return review process, encourage married clients with estates below the combined exclusion amount of $22,360,000 to reconsider formula clauses in their estate documents. Additionally, encourage clients who are residents of states with a state estate tax exclusion that is decoupled from the federal exclusion to reconsider their use of formula clauses as well. For example, a New York state resident funding a credit shelter trust with the full federal exclusion amount generates a state estate tax of more than $1.2 million at the first spouse's death.

While the estate tax applies to wealthier clients, CPAs should focus on planning for the orderly distribution of clients' assets, as well as on their traditional bread-and-butter skill of maximizing income tax planning opportunities. Since the credit shelter trust is designed to avoid inclusion of assets in the surviving spouse's taxable estate, there is no step-up in income tax basis under Sec. 1014 at the survivor's death on the appreciation of trust assets since the first spouse's death. The lost step-up in basis is a missed opportunity, especially if those assets would not have been subject to estate tax in the surviving spouse's estate. The dramatic increase in the estate tax exclusion amount may have unintended consequences for a client's existing estate planning documents that CPAs can help clients recognize and remedy.

Lifetime wealth transfer planning: Using the increased exclusion amounts

The TCJA presents an opportunity for clients to make significant gift-tax-free lifetime transfers using their federal estate, gift, and GST tax exclusion amount of $11,180,000. During the estate planning dialogue, be sure to describe the trade-offs associated with lifetime transfers by educating clients that lifetime gifts remove the future appreciation from one's taxable estate but at the expense of losing a step-up in income tax basis on the gifted asset.

In assessing the suitability of gifting assets during life, first help clients determine whether they have or are likely to have a taxable estate and whether they can afford to irrevocably part with assets. From conversations with the client and knowledge of his or her tax return, estimate the amount of capital the client needs to support a desired lifestyle for his or her remaining lifetime.

Example 2: An individual or couple have an estate valued at more than the current exclusion amount of $11,180,000 per individual or $22,360,000 per couple; their assets over and above what is needed to support their lifetime spending appreciates in their taxable estate, with the terminal value not passing to a spouse or charity subject to a 40% federal estate tax. Consequently, if assets are gifted, each dollar of appreciation outside the taxable estate saves 40 cents on the dollar in federal estate tax. Because of the forgone step-up in basis, however, assuming the transfer and subsequent sale of the assets costs 25 cents on the dollar in state and federal capital gains and/or income tax, the benefit decreases to roughly 15 cents per dollar of appreciation. For the gift to be beneficial, the individual or couple need to live long enough for the appreciation to overcome the hurdle of losing the tax value of the step-up in cost basis.

The CPA can help a client think through gifting scenarios by crunching and explaining the numbers. For example, if an individual makes a $1,000,000 gift with a cost basis of $500,000, the step-up in basis that is worth about $125,000 ($500,000 built-in capital gain × 25% potential combined federal and state capital gains and/or income tax rate) is lost. The gifted asset needs to appreciate to $1,833,333 (an 83.33% gain) to break even on the transaction ($125,000 income tax cost of the lost step-up in basis divided by 15% (40% federal estate tax rate minus the estimated 25% capital gains rate on the lost basis step-up)). The analysis results in the conclusion that if the individual or couple can survive long enough to see the asset appreciate over 83.3%, then the gift is a net positive to the family.

Retirement planning

Beneficiary designations

Review the tax return and supporting workpapers for any contributions to, or distributions from, retirement accounts. Articulate to your clients the importance of keeping all beneficiary designations on retirement accounts and insurance policies up-to-date. For instance, is an ex-spouse or deceased individual inadvertently listed as the beneficiary on an IRA or life insurance policy? Remind clients that these assets do not pass per the will; instead, they pass by the beneficiary designation form and should be coordinated with the overall estate plan.

Roth conversions

During the tax return review process, inform clients that lower tax rates provided under the TCJA may make Roth conversions more attractive. However, help clients analyze the decision and plan carefully because under the TCJA, a recharacterization, or redo, is no longer available. However, Roth conversions performed in the 2017 tax year can still be recharacterized by the extended due date of the 2017 tax return. Roth conversions will result in having to pay the income tax on the original amount, even if the value of the account decreases or the tax burden is higher than initially projected.

IRA investment fees

The TCJA also suspended miscellaneous itemized deductions, which include investment expenses. Review Schedules A, Itemized Deductions, noting any clients who were formerly paying their IRA investment fees from taxable accounts and deducting the fees as a miscellaneous itemized deduction. Discuss alternative arrangements, including paying the IRA investment fees from the traditional IRA. This strategy provides some degree of tax relief since the fees are paid with pretax funds.

Charitable planning

The TCJA increases the standard deduction to $12,000 for single filers and $24,000 for married joint filers. The increased standard deduction, along with the suspension and limitation of certain itemized deductions under the new tax law, results in far fewer taxpayers who will itemize their deductions. Thus, fewer clients will get a tax benefit from charitable giving.

Bunching charitable contributions

Check Schedule A for clients who historically made charitable gifts but who may opt to instead use the standard deduction under the TCJA. Since charitable gifts are fully controllable, it may be advantageous to bunch a few years' worth of contributions into one tax year. The more substantial charitable contribution can be made to a donor-advised fund and then paid to charities incrementally over the next few years. Bunching the contributions, rather than contributing smaller amounts annually, may help the client exceed the standard deduction hurdle, thereby receiving a more significant tax benefit for the charitable contribution.

Qualified charitable distributions

Examine tax returns for clients who are taking required minimum distributions (RMDs) and making charitable contributions. An IRA owner who has attained age 70½ may direct the distribution of up to $100,000 per year from the IRA to one or more qualified charitable organizations. This distribution counts toward satisfying the client's RMD and will not be taxable to the client. Instead of qualifying for a charitable income tax deduction, the distribution is entirely excluded from the client's income. It is imperative to discuss with clients the benefits of qualified charitable distributions under the TCJA.

More than just a tax return preparer

The tax return provides a framework for CPAs to gain a better understanding of clients' financial situations and raise relevant questions about their planning strategies and tactics. CPAs have the benefit of being able to see clients' overall financial and family situations through preparing their tax returns. CPAs can add value to their clients' lives by using the information on the return as a catalyst for a conversation about financial planning. With tax preparation fees no longer deductible as a miscellaneous itemized deduction, and with the rapid change in technology and simplification of the Code, clients may, unfortunately, view fees more critically and reconsider their engagement with a professional who solely provides tax compliance services. Financial planning is an opportunity for CPAs to shine as advisers and consultants rather than solely as tax preparers.



Robert A. Westley, CPA/PFS, is a CPA financial planner based in New York City. He specializes in the financial management and wealth planning needs of high-net-worth individuals and their families.He is a member of the AICPA Personal Financial Specialist Credential Committee. Theodore J. Sarenski, CPA/PFS, is chairman of the AICPA Advanced Personal Financial Planning Conference. He is also a past chairman of the AICPA Personal Financial Planning Executive Committee and a former member of the Tax Literacy Commission. For more information about this column, contact


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