Beyond the forms: The tax return as a beacon for financial planning

As a CPA financial planner, I have found that examining tax returns offers a valuable opportunity to enhance the client–adviser relationship. These returns contain extensive information about a client’s or prospect’s financial status, allowing advisers to uncover potential planning opportunities.

In running my own practice, I have made a part of my process asking the prospect or client for a copy of their tax return after they file. We then schedule a meeting to review my observations regarding the filed tax return and develop a road map for any actions we plan to take in their financial plan in response to the observations noted. Later in the year and where it makes sense, we put together a tax projection, taking into account items discussed while reviewing the prior–year return as well as changes to circumstances since our last meeting.

The marginal tax rate as a guide for tax-efficient investing

One can argue that understanding a client’s marginal tax rate should be one of the foundations of effective investment management. After all, investors seek to optimize after–tax performance.

Some advisers may operate under the assumption that a client with a consistently high cash flow or large portfolio is subject to the highest marginal income tax rate. However, that may not always be the case when also considering the tax treatment of the individual income flows, deductible expenses, or how changes in the client’s filing status and related tax brackets affect the bottom line.

Reviewing the tax return regularly to determine the marginal tax rate can help drive a tax–efficient financial plan in multiple ways:

• Evaluating the tax-equivalent yield: The tax-equivalent yield can be calculated by dividing the tax-exempt yield by the difference of one minus the investor’s marginal income tax rate. With that number in hand, the adviser can make decisions on the most suitable fixed-income allocation in a client’s portfolio. For example, one can discover situations such as when a business owner individual with a high cash flow may be receiving only tax-exempt bonds under the assumption of being in the highest marginal tax bracket when their income is significantly sheltered by net operating loss (NOL) carryforwards.
• Choosing whether to make Roth conversions: Understanding the current marginal tax rate can help the financial adviser and client decide whether a Roth individual retirement account (IRA) conversion makes sense when considering how the client plans to use each retirement account and the forecasted marginal tax rates throughout their lifetime.
• Deciding when to recognize more income: Determining what capital gain tax bracket the client falls under and where in that bracket’s band they fall can provide insights for recognizing more income. This can be done through a strategy such as gain harvesting while in a 0% capital gains bracket or not doing a Roth IRA conversion when it will result in more income recognized in the 15% tax bracket in addition to the ordinary-income marginal rate consideration.

In determining the marginal tax rate, it is worth paying extra attention to the use of any carryforwards on the tax return being reviewed as well as the bank of carryforwards left for future use. This would include carryforward credits, carryforward passive losses, and, in the case of business owners, NOLs.

Capital loss carryforwards

Form 1040, U.S. Individual Income Tax Return, Schedule D, Capital Gains and Losses, will detail any capital losses being carried forward. To the extent the carryforward and/or the net amount being harvested on an annual basis is significant, it would be prudent to give thought to how gains can be harvested that would make use of this tax asset.

Qualified dividends versus ordinary dividends

Lines 3a and 3b of the 2024 Form 1040 list the qualified dividends and ordinary dividends, respectively, earned by the client. When a low ratio of qualified vs. ordinary dividends is revealed, it may be worth reviewing the portfolio’s asset location, given the preferential capital gains rate that applies to qualified dividends.

Adjusted gross income

A review of adjusted gross income (AGI) that considers thresholds for items such as the 3.8% net investment income tax and Medicare premium increases or the loss of eligibility for various tax credits can help spur discussions around timing of strategies such as tax gain harvesting, Roth IRA conversions, and/or significant business expenditures.

Similarly, understanding where the client stands with respect to AGI can be helpful in assessing eligibility for a traditional IRA deduction or a Roth IRA contribution.

Qualified business income deduction

For clients who claim the qualified business income deduction as a specified service trade or business, it is imperative to have an idea of where the client’s taxable income stands, given the phaseout limitation kicks in at $394,600 for joint filers and $197,300 for other filers in 2025.

Depreciation and the real estate professional election

Schedule E, Supplemental Income and Loss, of Form 1040 shows the tax–basis income statements of any rental real estate owned by the client. To the extent there is significant undepreciated basis of the client’s properties and they are in a net rental income position or a real estate professional who would be able to deduct real estate losses against other sources of income, a cost segregation study should be explored.

As for the real estate professional election itself, I have too often come across tax returns where the client is eligible for the election but failed to make it, whether because of ignorance or an unqualified tax return preparer’s negligence. Identifying such a mistake can powerfully impact the tax filing to the client’s benefit.

Charitable planning and the itemized deduction

Since the Tax Cuts and Jobs Act, P.L. 115–97, went into effect starting with the 2018 tax year, fewer taxpayers itemize and, as result, a tax benefit may be lost. Schedule A, Itemized Deductions, should be checked to identify an opportunity for bunching or qualified charitable distributions.

Charitable contribution bunching

For clients who are charitably inclined, a bunching strategy, which involves making a few years’ worth of charitable contributions in one year, should be explored. If substantial, such contributions can be facilitated via one large contribution in a single year to a donor–advised fund (DAF) and then distributed from the DAF to charities over the span of a few years.

Example: Filing under the married filing jointly status, taxpayers with $10,000 in state and local income tax paid and $15,000 in annual charitable contributions would receive the benefit of $60,000 in standard deductions over two years (using the 2025 standard deduction of $30,000). By bunching two years’ worth of charitable contributions in one year, they would receive the benefit of $40,000 in one year and $30,000 in a standard deduction in the second year, for a total of $70,000 over the same two years.

Qualified charitable distributions

For IRA owners who are subject to required minimum distributions (RMDs) and making charitable contributions, the use of qualified charitable distributions should be considered. They can direct the distribution of up to $108,000 in 2025 from the IRA to one or more qualified charitable organizations. In so doing, the amount directed to a charity still satisfies their RMD but will not count as taxable income. The result is comparable to a client who itemizes and deducts charitable contributions.

Beneficiary designations

When I see contributions to or distributions from retirement accounts on a tax return, it is an opportunity to remind clients to review their beneficiary designations. Furthermore, it should be emphasized that retirement accounts and life insurance policies pass by beneficiary designation form, overriding any will or trust document.

This year, multiple media outlets published a story about a man who left $1 million in his retirement accounts to a woman he broke up with 26 years before his death because he never updated his beneficiary designations (see Volenik, “They Broke Up in 1989, but Now His Ex–Girlfriend Is Inheriting His $1 Million Retirement Account After Nearly 40 Years,” Yahoo! Finance (June 14, 2024)). One can only imagine the legal dispute process that such a case leads to — and it is a legacy no one wants to leave behind.

The superpower of CPA financial planners

The CPA financial planner’s superpower is having the unique aptitude to read a tax return and understand the story it conveys. Such a skill set can and should be used to gain a more intimate understanding of a client’s financial framework when providing financial planning advice. Taking the time to review the tax return and extract data points such as the ones highlighted in this column when developing a financial plan will only add value to the client–adviser relationship.