The content of investment advisor’s annual year-end tax planning story might seem self-evident this year, considering the major tax developments brought along with the passage of the Economic Growth and Tax Reconciliation Relief Act of 2001. Yet as is the case with many planning issues, the most obvious angle is not always the best one.
In our July issue, Editor-at-Large Andrew Gluck outlined the important points of the tax act and provided analysis of the manifold implications of the legislation. Since then, Andy’s lead has been followed by pundits, industry professionals, and journalists who have devoted even more ink to the issue.
Beyond any given tax legislation, however, year-end tax planning–and tax planning in general–is akin to a game of strategy. It’s as if you are seated on one side of a huge chess board, across from Uncle Sam plotting his moves. As in chess, keen foresight, flexible strategies, and long-range planning is needed to ultimately be successful in the tax game. But how many advisors approach tax planning in this fashion? With this in mind, we talked to leading advisors and tax professionals to gain the knowledge that will help you and your clients win this very intricate, absorbing–and rewarding–contest. Here are 10 tax planning reminders that you can’t afford to ignore. And following this story are three other features (see Table of Contents on right) that focus on specific tax strategies and a mutual fund that does the right thing, taxwise.
1. Get in the Game
What Your Peers Are Reading
Tax planning is not only the purview of CPAs or whoever does a client’s actual tax returns. Case in point: Bernard Kiely, a CFP and a CPA, does both financial planning and tax returns in his practice, Kiely Capital Management in Morristown, New Jersey. Some of his clients get the whole nine yards–from comprehensive planning to the completion of actual tax returns. Others only get one or the other. We’re going to examine how Kiely advised a wealthy client who preferred to handle his own financial planning and relied on Kiely only for tax work.
In April 2000, the man came to Kiely’s office and submitted financial data for the prior year that included a $1 million buyout package from his firm. “That amount of income from 1999 caused this client to have $50,000 in state income tax, but he didn’t actually write the check for that amount until when he came to me in April 2000,” Kiely says. “What planning opportunity did we miss?” In fact, waiting until 2000 to pay the whopping state income tax, rather than during the prior year when his income surged, caused all manner of problems. State income tax is, of course, deductible from federal taxable income, but because the man hadn’t written the state tax check until 2000, he couldn’t deduct that amount in 1999 when his income actually increased. Instead, the man listed the $50,000 deduction in 2000 when his income had already returned to nominal levels. “His normal income wasn’t enough to justify a $50,000 state income tax deduction and he got caught in the AMT,” Kiely says. “He wound up paying an extra 10 grand.”
Now, what’s the moral of the story? The facile interpretation would be to simply harvest the notion that one should pay state tax early in the year that income actually surges so as to avoid the AMT. Yet that reading would be akin to thinking that Moby-Dick was really a story about a ship captain chasing a large whale.
In this case, an advisor should glean the idea that CPAs, or whoever handles a client’s tax returns, cannot possibly be held responsible for effective tax planning. For one thing, it’s simply too late to get anything done once April 15 rolls around–the time of year when CPAs who are not PFSs most likely will see their client for the first time. “Tax planning for a certain year is something that is done before that specific year is finished,” says Kiely, before adding in reference to the unfortunate aforementioned client, “Look what happens when you wait until the following April.”
Yet financial planners often give only passing attention to the income tax issues of their client’s expenditures and various forms of income. Perhaps they have decided to slough off the actual work of completing a client’s tax returns–it’s a very labor-intensive and low-profit-margin proposition. But it’s of paramount importance that an advisor recognize that the actual filling out of a tax return is a quasi-clerical task that in no way should be thought to include actual tax planning. As Steven Kanaly of Houston, Texas-based Kanaly Trust Company says, “Expecting [accountants] to do real tax planning come April is crazy. First of all, the year is already up. Second, they’re so bogged down in trying to get all those returns done that there is no room for actual planning. Tax planning is the financial planner’s job.”
2. Make Use of Itemized Deductions
So what does Kanaly mean by “tax planning?” There is no doubt financial planners across the country are already knee-deep in family partnerships, bypass unified credit trusts, and other estate planning tools. They may even do some investment tax planning, harvesting losses to match up with gains. But what Kanaly and others refer to when they talk of a client’s tax plan is sitting down with a client and scheduling every taxable event–whether it be expenditures that are deductible or the realization of income that will eventually go to AGI–so that the timing is done in the most tax-efficient manner. “Timing, timing, timing,” says Robert Doyle, a CPA and PFS with the St. Petersburg, Florida, investment advisory firm Spoor, Doyle & Associates. “You have to work it all out.”
Where to start? It may seem self-evident to some already involved in tax planning, but an advisor should make sure his clients are making the best use of the itemized deductions. The IRS allows people a standard deduction (SD) each year that can be taken in lieu of all other itemized deductions. (See sidebar on page 50 for information on the standard deduction and what is included in itemized deductions.)
For instance, a planner has a client who has $3,500 in deductions each year, but never is able to claim them since they don’t exceed the standard deduction. “Have the client try to bunch as many of those deductions into one year as possible,” Doyle says. “That way, he might conceivably have $7,000 in deductions one year, which would exceed the SD by $2,500. You might have just saved him $800 or $900.”
The question then becomes, how to bunch these itemized deductions into a single year. Looking at the list, one could allow a client to pay his advisory fees twice in one year or manipulate the month that the first and last mortgage payments of the year are made. The December 2000 mortgage payment could have been made in January 2001, and the January 2002 payment could be made in December 2001. Two extra mortgage payments were just squeezed into a single year to potentially offset large income. In other words, a serious tax planner has to sit down and schedule when a client will pay for all of the expenses that can be listed as itemized deductions.
Another issue at stake is that certain itemized deductions have to exceed a preset amount of a person’s adjusted gross income (AGI.) Medical expenses, for one, can only be deducted once they have exceeded 7.5% of a client’s AGI. For example, if a client’s AGI is $100,000 and he spent $8,000 on medical expenses, then only $500 of that amount can actually be deducted. The same concept applies for miscellaneous deductions (MD), which must exceed 2.5% of AGI. This not only makes it especially important to bunch medical and MD expenses into the same year when trying to get over the standard deduction hump, but also broaches entirely separate planning issues.
}For instance, a client could have been itemizing her deductions for years without ever including a cent from medical or MD expenses. It’s then up to the planner to have that client bunch those costs into a single year so that they exceed the percentage floors set by the IRS. “There are lots of things a planner can do,” Kiely says. “Nursing home costs are often enormous and thus can be bunched together. Elective surgery, even dental appointments” can be used. Clients could schedule a root canal for either January or December, depending on the year in which they would like the cost of the procedure to be deductible.
3. Remember the Time Value of Money
Once you have made sure your client is making the best use of his itemized deductions with respect to the standard deduction, it’s now time to consider the time value of money, according to Mike Reuben, a CPA and PFS and director of client tax services for Bessemer Trust Company. What this means is taking advantage of the time-honored tax planning strategy of accelerating deductions into the current tax year and deferring income into the following year. A perfect example of this is deferring a year-end bonus (even though there might not be many of them this year) from December into January. “Should you do that, it means that the state and federal taxes that would be due on that bonus less what has already been withheld don’t have to be paid until the following year,” Rubin says.
Here’s an example: Rubin has a client who is due to receive a $1 million bonus this December, yet the client successfully petitioned his superiors to defer that money until January at Rubin’s urging. Twenty-eight percent will be withheld from the bonus for federal taxes, yet the extra 11% (the man is taxed at the highest personal income tax rate of 39.1%) will not be due until April 2002. “That’s a year of opportunity cost on the $110,000 that was deferred,” Rubin says. “If that money generates only 5% over the course of that year, we just made him $5,500.” This strategy especially makes sense over the next several years when the income tax brackets are incrementally going down 1% every 12 months. “When he finally does pay tax on that bonus, it will be at 38.1%,” Rubin says. “I saved him 1% on $1 million–that’s another $10,000.”
This goes for deductions as well. Estimated state income taxes are normally due in January, April, July, and October, and state income taxes are federally deductible. Therefore, a client can be counseled to make the Jan. 15 estimated state tax payment in December 2001. Also, since mortgage interest is deductible, a client can pay his January mortgage bill in December. Many advisors noted that municipalities will also accept local property tax payments early. “You can really fool with these various payments to make the client as tax efficient as possible,” Doyle says. “You just have to be willing to put in the time that’s necessary.”
4. Plan for Certain Events
Just as it’s possible to accelerate deductions and defer income in order to preserve assets that otherwise would have gone to the government, it’s also possible to use this strategy to plan for certain extraordinary fiscal events in a client’s life. “Generally speaking, you want to accelerate deductions and defer income, giving consideration to the AMT, except when you want to plan for a large event,” Rubin says. What qualifies as a large event? “Cashing in large capital gains, the necessity of exercising stock options, the sale of a residence, having a child that was formerly a dependent come of age, setting up a private foundation–these are all things you have to plan for,” Rubin adds.
Indeed, if you, as the advisor, knew that a client wanted to liquidate highly appreciated stock holdings, then you might want to consider deferring (and/or accelerating) deductible expenses like state taxes, charitable gifts, and business expenditures into that year. There are a couple of reasons for doing this. First, you are saving the client from having to pay a larger-than-normal amount of taxes in a single year. Second, depending on a client’s base AGI, the additional gains may push them into a higher tax bracket. “If an unmarried client is making $110,000 a year, and suddenly has some event that accounts for another $30,000 in income, then he will be pushed into the next tax bracket. You’ve got to plan for that and make sure there are sufficient deductions to offset this possibility,” says Doyle.
Third, there are a host of AMT considerations. The government has made it so that people can only lower their AGI so much through deductions with this “shadow tax system,” as Kiely refers to it. If you deduct too much with respect to your income, you’re going to pay AMT tax. Therefore, an especially high-income year may be the perfect time to execute a host of deductible events that in any other year would otherwise push a client into the AMT. For instance, Rubin says that a client wants to gift $100,000 to a certain charity. In normal years, his salary would be so large that deducting that amount would push him into the AMT. A high-income year with the liquidation of appreciated stock, however, would allow him to make the desired charitable contribution and receive the full amount of deductions.
There are four other very important examples of concepts that involve shifting deductions and income. Take “conversion experience.” When most people hear the phrase, they might think of religion. But it could apply also to something of a very secular, yet equally joyful, event. “I love converting regular IRAs to Roths,” says Rubin. “The Roth is the single greatest investment vehicle ever made, in my opinion.” That said, clients with previously existing IRAs cannot make the conversion unless they have less than $100,000 in AGI. “What you have to do is accelerate deductions and defer income so you have that type of year,” says Bert Whitehead, the advisor and founder of Cambridge Connection of Franklin, Michigan. “I actually did this myself.” Indeed, Whitehead says he took a large bonus at the end of 1997, slashed his salary in 1998 so that he met the conversion income requirements, and then took another large bonus in 1999. He also accelerated certain deductions into 1998 as well.
Don’t ignore Section 179. Tax experts seem to love to refer to these obscure sections of the tax code that could wind up saving clients thousands of dollars in the end. Perhaps there’s no better example of this than Section 179 provisions. Section 179 allows a client to accelerate the deductions from the depreciation of certain business assets into a single year, up to $24,000 in 2001. So if a business owner bought a car, which usually depreciates over five years, he can make it all count in a single year under Section 179.
“This is great if a client is going to make a business expenditure and the client is having a great year,” says Rubin. “You can make it all count against those earnings.” Whitehead notes one exception to this principle: If a client desperately needs the business item, but is having a bad year, he can buy the item with a credit card in 2001, put it to use immediately after purchase, yet also claim it as deductible in 2002–as long as that is when he pays the credit card bill.
Deferred compensation is also a great way to put income off into the future. Remember that one might want to do so in order to take advantage of large deductible expenditures, such as setting up a private foundation or paying substantial medical expenses. One may also want to defer income in order to keep a client from being forced into a larger tax bracket in any given year. “What this involves,” says Herbert Daroff, an advisor for Baystate Financial Services in Boston, “is an employee asking his employer to pay part of his salary or a bonus at some time in the future.”