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Although it seems that nothing could put a damper on a conversation faster than the discussion of taxes, asking for a client's tax return can be one of the most powerful and rewarding tasks you may ever accomplish with that client.
Especially if you're not a CPA yourself, you might initially think that your own tax return is hard enough to understand, so you wouldn't bother asking for a client's. Or worse, what if the client has a tax-related question that you can't answer? However, once you understand the story behind the numbers, I think you will find a tax return's bark is bigger than its bite.
To begin, don't be intimidated. Even though the number of pages of the tax code keeps increasing (up 50% between 1995 and 2004) most of these regulations do not affect the majority of U.S. taxpayers. Studies show that 83% of the tax code does not apply to 71% of taxpayers who obtain all of their income from wages and investment income. So all you really need to know are the basics to get started.
You do not have to be a tax expert to utilize a client's tax return effectively. What you do need is a strategic framework for getting to the "story behind the numbers," to know which lines to look for, and how to ask the right questions to determine the potential opportunities from each line or number indicated.
In this article, we will focus on using a client's 1040 to uncover wealth management opportunities, and we'll also suggest how advisors can work with accountants for both parties' mutual benefit (see "Acquiring Affluent Clients Through CPAs," sidebar at end of this article). But tax returns do not exist in a vacuum, so our other stories in this special report address some recent tax developments you should know about, and one advisor's approach to tax loss harvesting using exchange traded funds. Finally, in our regular "Wealth Advisor" column in the November issue of Investment Advisor, we'll explore ways to use the 1040 to uncover your clients' hidden assets, to gain referrals, and network with spheres of influence.
Building the Framework
At its simplest, this strategic framework for finding the story "behind the numbers" is based on the concept that every line of a 1040 corresponds to a life event, each representing an opportunity for you. By understanding the "why" and "what" of each line you will gain insights into each of your client's past, present, and future financial behaviors, leading to a better understanding of:
Who your clients are: Their investing and buying behaviors
What their specific issues are: Their needs
How they like to be serviced: To deepen relationships
In essence, you are profiling in reverse, letting the return "talk" to you rather than asking your clients or prospects for all the information. Think about these questions as you are "listening" to the return.
- What is the source of this income? Is it repeatable? Do I manage the assets that generate this income? Are my clients utilizing this income in the most effective manner?
- Does the number relate to a life event that can be resolved more effectively in the future?
- How can I add value to our relationship? What can I do to be viewed as the primary advisor?
In other words, to make this exercise the most impactful, always keep a lookout for these four opportunities. The ability to:
Uncover wealth management opportunities;
Unearth hidden assets;
Gain referral opportunities;
Network with centers of influence.
By reviewing and addressing the individual's needs, as revealed on the 1040, you have a window into that client's past, which can lead to your providing future wealth solutions. To make your analysis more user friendly, break down the wealth management opportunities into the four tenets of wealth management: wealth enhancement; wealth transfer; charitable planning; and asset protection.
For each of the four tenets, we will share with you some examples of how to use the tax return to uncover opportunities. Please note that all references to specific line numbers correspond to tax year 2005.
Opportunity #1: Wealth Enhancement
An example of adding value via wealth enhancement can be something as basic as looking at Schedule D (the capital gains and losses report), line 13, which indicates the long-term capital gain distributions from mutual funds. Is this number significant? If your client is tax-sensitive, can you deliver a more effective solution, such as a tax-aware fund or a managed account? (Or ETFs--see part three of this special report, here.)
Now take a look at line 7, Wages, salaries, tips. Is this number the same as the prior year? Is it much higher? Does it represent an exercise of stock options? If so, why were they exercised at that time? Was it to meet cash flow shortages? If so, this could be an issue in the future, and you may want to explore how it could be solved more effectively with a customized credit solution, for instance.
Next, look at line 21, Other income, to see if this is consulting income or self-employment income. If so, determine whether the client is taking full advantage of the retirement plans available to the self-employed.
Now let's look at line 37, Adjusted gross income (AGI): Is it below $100,000? Did the client roll over an IRA? Would a Roth IRA be a more effective strategy to help meet the client's goals? If not, should you start planning for 2010? Recently, Congress passed a bill to eliminate the income limits on Roth IRA conversions effective in 2010. In the meantime, you may want to suggest that the client contribute the maximum each year to a non-deductible IRA. Then, in 2010, the client could convert non-deductible IRAs to Roth IRAs.
Opportunity #2: Wealth Transfer
The estate tax was not repealed this past summer, but instead will continue to become more lenient up until 2010, at which time it will be repealed for that year alone. Thereafter, it will revert back to pre-2001 tax levels. With that in mind, and assuming that no Congressional action changes the timing or amounts affected by the estate tax, we need to continue to plan as if the estate tax exists, with the goal of transferring wealth without incurring any gift tax. To help uncover these types of opportunities, go to the tax return.
Again, take a look at Schedule D. If the client sold an appreciated security, you may want to review the portfolio for other securities with the potential to appreciate. From here, you could discuss the benefits of a grantor retained annuity trust (GRAT) or charitable lead annuity trust (CLAT), given that we are still in a fairly low interest-rate environment.
Now take a look at Schedule B (interest and ordinary deductions report) for interest income. Does the client have excessive amounts of cash on hand? If so, then a sale to an intentionally defective grantor trust (IDGT) or dynasty trust may be an option since seed money is necessary. Are these strategies too complex for your clients? Then you may want to suggest annual exclusion gifting with those securities. Not only does this get the asset out of the estate, it gets out all the future appreciation as well.
On Schedule B, see if you can uncover why the various accounts exist. Perhaps the client is saving for a grandchild's education. If so, it may be appropriate to suggest using a 529 college savings plan instead. These plans can be a more effective wealth transfer and wealth enhancement strategy. This is even more relevant today with the recently signed Pension Protection Act of 2006, which has a provision that makes permanent the tax-free status of withdrawals from 529 Plans.
Opportunity #3: Charitable Planning
According to the Internal Revenue Service, the average charitable itemized deduction for taxpayers with AGI over $200,000 is $22,000.
Look at your clients' charitable deductions lines on Schedule A, lines 15-18. First calculate if they are giving more or less than the average. If more, can they be giving more effectively? Most people give cash outright. Would a charitable remainder trust (CRT), a donor-advised fund, a direct gift from their IRAs, or some other solution work more effectively toward their bottom line? The aforementioned Pension Act also opened up new planning opportunities for charitable giving. For 2006 and 2007, taxpayers over age 70 1/2 will be allowed to donate up to $100,000 per year to charities directly from their IRA or Roth IRA accounts, but will not be able to claim a tax deduction for these types of charitable contributions.
The new rules could be quite attractive to residents of states with no state income tax (e.g. Florida, Texas, Nevada, and Washington) because relatively fewer taxpayers in those states itemize (because they have no state income tax to deduct against their federal tax). In addition, this may appeal to taxpayers who will look to maximize their ability to claim income tax deductions due to the AGI 50% limitation. These rules do not affect other gifts to which the limitations apply.
There's one question you should ask yourself: Are you having charitable giving conversations with your clients? If not, you are not only missing a valuable opportunity to gather more insight into your clients' financial behaviors and priorities, but you may also be missing out on a business opportunity. Be warned that some other advisor may be doing this for your clients and getting their attention, which could motivate them to move their assets. In a 2005 PNC Advisors' survey, 53% of affluent investors with more than $1 million in assets stated that they are charitably inclined, with the wealthiest among them particularly concerned about the "how," "who," and "what" of giving. In fact, 28% of those in the survey who had investable assets of $10 million or more said that "deciding which financial charity to donate to was one of their top three financial worries."
Opportunity #4: Asset Protection
The 1040 also can give you valuable insights on how to help your clients protect their assets by minimizing risk, both to the clients' portfolio and lifestyle.
One of the key threats to an investor is having a concentrated position. While a concentrated position may have made your clients wealthy in the past, it is not good strategy for preserving wealth. Concentrated portfolios are less secure than diversified ones for one simple reason: individual companies are liable to fail, but the economy, as a whole, is unlikely to do so. In a recent JPMorgan study, we compared the companies listed in the S&P 500 Index in 1990 to those listed in 2001 and found that half of the companies were no longer represented in the Index. Over that decade, many of these companies suffered serious price declines, and some went bankrupt. Unfortunately, most investors could not foresee what was coming.
To uncover concentrated positions, let's take another look at Schedule B. Use the dividends to figure out how many shares it would take to generate this income. In addition, look at Schedule D to understand what comprised their capital gains. Charitable deductions on Schedule A (for itemized deductions) may also give you some insight. See if your clients consistently give away appreciated stock. Investment interest expense may also give you a clue. As you know, people often use margin loans to monetize a concentrated position. Form 6251, alternative minimum tax (AMT), line 13 can be another place to look. Exercising incentive stock options (ISO) may also indicate a possible concentrated position. Keep in mind that if you spot a concentrated position from employer securities, it is very likely that the client's 401(k) plan is concentrated as well.
Take a look at page one of the 1040, line 31A, alimony paid: Is your client in a second marriage? Is that marriage at risk? According to a 2002 report (available here) from the Centers for Disease Control (CDC), the probability that second marriages will end in separation or divorce is 23% after five years and 39% after 10 years. With such an ominous statistic, can you do anything today to protect your client from potential future harm? Have your clients looked into estate planning techniques to protect their children's inheritance from the new spouse in case of death? Take a look at Schedule E (supplemental income or loss report). This generally represents the client's illiquid assets. Explore whether they would be protected in case of death or divorce, and whether liquidation might be forced at an inopportune time.
Also remember to look at the basics of the 1040, such as your client's home address. Has that neighborhood gone through significant appreciation? When was the client's property and casualty insurance last reviewed? Millions of homeowners are underinsured without being aware of it. A common source of underinsurance is the widespread practice of insuring one's home for its market value rather than for its replacement value. It's not unusual for the difference between the two values to range anywhere from 10% to 20%. The gap is often wider, however, because many homeowners neglect to keep appraisals up to date. A home that has substantially appreciated but is insured on the basis of an outdated appraisal will be significantly underinsured.
To review, remember that if you let the tax return "talk" to you, you could potentially uncover a host of wealth management opportunities. Research from John Bowen's CEG Worldwide has shown that wealth managers bring in almost 30 times more assets than product-centered advisors. In addition to having greater assets under management, wealth managers also have fewer yet better clients, less concern about client retention and fee pressure, and overall they are better insulated from the whims of the marketplace. Whoever said taxes were boring?
Susan L. Hirshman, CFP, CPA, CFA, CLU, is a managing director for JPMorgan Asset Management in New York, developing strategies to provide wealth solutions to the affluent market. She can be reached at