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

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.”

Setting these up, however, is very tricky, Daroff and Whitehead caution. Whitehead, for instance, admits that his tactic for bringing his income under $100,000 to make the Roth IRA conversion was “pushing the envelope.” The reason for this is that the IRS considers income taxable to a certain year if the decision to defer was made by the employee. Daroff says the IRS will then find the client in what the IRS calls “constructive receipt” of the payment. No one interviewed for this article believed that the IRS would have a problem with deferring a bonus from, say, December 2001 until January 2002. But issues of constructive receipt seem to arise when moving large portions of salary around over long periods of time to fit a client’s needs.

“You can’t just say, ‘I’ll take this salary when I have a bad year and am in a low tax bracket,”‘ Daroff says. But Daroff thinks he has a solution: writing a deferred compensation plan with very specific provisions that would trigger the receipt of the deferred salary. That way, he says, the discretion to receive the salary wouldn’t be solely in the client’s hands, but rather under those provisions. For instance, the plan document could read, “If my compensation falls below [a certain amount] then my employer will pay me the money.” Or, “If I, as the employee, bring my boss a bill for my son’s college tuition, then I am to receive [this amount of money].” Or one last one, “If I, as the employee, pay medical expenses in the form of nursing home costs or make a certain amount of charitable gifts, then I am to receive [this money].” “There’s a lot of gray areas,” Daroff says. “You’d have to play around with it a bit.”

A few notes on deferred compensation plans, however. Estate attorney Jeff Scroggin, of the Roswell, Georgia, firm Scroggin & Associates, suggests that the incremental lowering of the rates could make deferred compensation a nice play in the present. “It’s only 1% per year for five years, so you’d want to string it out, but if you go that long, you could be getting some nice bang for your buck,” he says. He also suggests the strategy of deferring compensation all the way into retirement when a client’s AGI, and tax bracket, should fall dramatically.

Non-qualified dispositions are another important tactic, considering the trend today for corporations to compensate employees, at least in part, with stock options. Should a client exercise options, the spread between the value of the options when they were given to the employee and their value when exercised is included as income for purposes of the AMT. This is a very important concept: If a client has stock options that were given at $1 and he has now exercised those options at $41, while the $40 in unrealized gains do not count as income for purposes of AGI, they are for AMT. Kiely gives an example of how this played for a client. The client’s federal taxes in 2001 came to $47,749 and his AMT was $44,094, Kiely says. “Since the AMT was lower, the client wouldn’t have to pay any [AMT taxes],” he says. But once the client exercised his stock options for a $150,000 gain, the AMT jumped to $95,634, leaving the client with some $50,000 extra in AMT to pay. “He went ballistic,” Kiely laughs.

There are a few ways to handle this. Keep in mind you can’t accelerate deductions to knock off AMT, since most deductions do not count there. Kiely says that you can enact what is known as a non-qualified disposition. The trick here is that if you sell the stock in the same year that you exercised the options, the spread does not count toward the AMT. The client’s regular income would jump, leaving the advisor with several more options. Deductions can now be accelerated since the gains are charged to both AMT and regular income. Or the advisor can take capital losses or use carry-forward losses, especially since the non-qualified disposition will be a short-term sale and carry-forward losses are normally short-term in nature.

There is another way to handle this issue. Kiely notes that there is a window of approximately $3,600 between the client’s AMT and income taxes before the options were exercised. Thus, if the options don’t have to be exercised that year, the advisor can exercise $3,600 worth of options without any AMT concerns. “You should be doing this every year if a client has stock options,” Kiely says in reference to figuring out the “window” between AMT and regular income tax and then making use of it. But, if it’s a last-minute issue and the options have to be exercised, Kiely suggests accelerating income from either future years or by selling appreciated stock to get the income tax level above the AMT figure of $95,634. “If you know you have to do this, then you might as well make use of the fact that you’re going to be paying at least $95,000 in taxes that year. Don’t make it AMT taxes that are paid.”

A last bit of advice on how to accelerate income is to do a non-qualified disposition on only the amount of options that will push you above the AMT figure. Doing these things and saying a prayer might get you through.

5. Roll Over, Beethoven

If you’re looking for extra deductions–or you want take advantage of today’s low mortgage rates–a client should think about rolling other debts into a home equity loan. This is a comparatively easy concept to understand: The interest is usually deductible and loans can be obtained in the 7% area, while interest on car loans and credit cards is not only not deductible, but also comes at a much higher rate. “It’s one of the first things that I ask a new client,” says Kiely, who tells a particularly apt story involving this strategy. A client had $23,875 in credit card bills and $18,404 in car loans as of June 2000. “We got a home equity line of credit and paid off those loans,” he adds.

One other tip on this issue: the interest on the home equity line of credit will most likely be 100 or 200 basis points higher than the going mortgage rate since that creditor has second dibs on the asset behind the first lender. Therefore, Kiely suggests clients take advantage of the opportunity to refinance the first mortgage at today’s low rates. “When you refinance the new mortgage, don’t take out $50,000, but borrow $75,000 and use the extra money to pay off car and credit card loans,” he says. “That way, you get a better rate.”

6. Kill Two Birds With One Stone

It’s one of the oldest tax tricks in the book, but it’s often overlooked, according to Rubin. “When you’re going to make a charitable donation, don’t give cash,” he says. “Make the donation with appreciated stock that you would otherwise have to pay capital gains on.” Rubin tells a story about a couple he had as clients. The husband was sitting on hundreds of thousands of dollars in highly appreciated company stock, while his wife was writing $1,000 checks to her favorite charities. “You gift the stock, the charity gets protection from taxes, and, the best part is, you not only lose the capital gains taxes, but you get to take it all as a deduction.”

7. Check Before You Buy

It’s no secret that most advisors prefer using mutual funds for their clients, rather than purchasing individual securities. Better to leave the actual investment management decisions to an expert and focus on the clients’ wide-ranging financial picture. That’s great, but it begs the question of how many advisors actually take a look at the capital gains exposure of a fund before putting their clients’ money into it. Over the last five years, the stock market has experienced an unparalleled bull run. A result of this, though, is that many prominent mutual funds now have tremendous unrealized gains sitting in their positions.

Consider where the Stein Roe Capital Opportunities Fund stood in December 2000: It had a total of $564 million in net assets, with $221 million of that tied up in unrealized appreciation. Without first checking, someone who bought shares in the fund would be exposing less than half his total investment to either long or short-term capital gains taxes–the fund didn’t specify how much of those unrealized gains were tied up in either one. Similarly, William Harding, an analyst for Morningstar, says, “Check to see if the number for net unrealized gains is negative, and if so, it means the fund is carrying forward a tax loss.”

Of course, one wants to be careful about buying into funds in such scenarios, in that past losses might be indicative of future performance. “Ideally, you want to catch a proven manager starting a new fund, but if you can’t do that, definitely check to see their capital gains exposure.” At the very least, take a gander at the tax efficiency ratio provided for the funds tracked by Morningstar. Harding says the ratio is an expression of a fund’s pre-tax returns divided by post-tax returns. “The closer to 100% you get, the better.” (See “Efficiency Expert” on page 60 for further insights into tax-efficient eguity investing.)

8. Consider Tax-Efficient Funds

Morningstar tracks 65 tax-managed funds, according to Harding. What’s interesting about those figures is that 42 of those funds were started between 1997 and 1999. “There has definitely been a rise in the popularity of tax-efficient funds,” says advisor Ori Pagovich, an advisor with New York-based Cowen Financial Group. “They’re popping up all over the place.”

Pagovich should know: He’s moved several of his clients into tax-efficient funds after precipitously negative returns in 2000 were compounded at the end of the year by large distributions. “I had a client who had a $1 million portfolio with a large mutual fund company that was down 15% last year,” he says. “At the end of the year, he received $35,000 in distributions. He simply wasn’t trained for such an eventuality.”

Pagovich notes how it was easy to write off grossly inefficient tax investing–there are stories of fund managers taking enormous gains without the slightest attempt to offset the gains with losses or tax-lot accounting–when the fund was returning 30% to 40% per year, as was common over the last five years up until last spring. Now, when 8% is a good return, he has refocused on the impact of taxes on total return. “Some of these managers don’t pay the slightest attention to after-tax returns,” he says. “You need them to be on the same page as you and your clients.”

Harding, for one, says work that his firm and others have done indicates that a full 200 to 300 basis points per year in return can be eaten up by taxes. “The events of the last few years have brought a renewed awareness to this topic,” he says. The law has helped a bit as well. Beginning this past April, the Securities & Exchange Commission is forcing mutual fund companies to include after-tax returns for one-, five-, and 10-year periods in their prospectuses. However, a note should be made about tax-efficient funds. Forbes recently reported that of the 237 equity funds that received its highest tax efficiency rating, the highest ranking on the list with “tax managed” in the name is also 108th in 2001 return, the Vanguard Tax-Managed Growth and Income Fund. Clearly, some funds that aren’t called “tax-managed” could be run in just such a fashion. An advisor simply needs to check the historical distributions and unrealized capital gains exposure in the fund’s prospectus.

9. Do It Yourself

Tax-efficient funds aside, there are a few other methods an advisor can employ to keep his clients’ equity investments in mutual funds tax efficient. First, take advantage of tax-lot accounting. Also, Whitehead suggests making the most of the decisions of which mutual fund investments should be placed in qualified plans like 401(k)s and IRAs, where, of course, year-end mutual fund distributions are tax-deferred. “I think of this as another round of asset allocation,” Whitehead says. “The large-cap funds and, especially, the very tax-efficient index funds should be left outside of the qualified plans.” The reason for this, he says, is that you would expect a large-cap manager to trade less frequently than one for a small-cap fund. Not surprisingly, small-cap funds and emerging-market funds are the investments Whitehead places in the plans. “Those funds will be more actively managed,” he says. “So we expect more capital gains from trading.”

Whitehead takes advantage of the fact that mutual fund companies report short-term capital gains and income from dividends together on 1099 forms. In that form–as income–those short-term gains could, of course, be taxed at 39.1%, depending on the client’s bracket. Yet what happens if a client has some short-term losses that either are being eaten up by long-term gains or, worse, not being used at all? Whitehead will pull out the short-term gains from income statements on Schedule D of the tax return and transfer them to Schedule B, making notations in both places describing his actions.

Whitehead provides an example of a client who saved $5,000 last year with this strategy. The man had $35,000 as mutual fund income on his 1099, $25,000 of which were short-term gains. The man also had $40,000 in short-term losses and $50,000 in long-term gains. So instead of having $10,000 in long-term gains (taxed at 20%) and $35,000 in income (39.1%), the client wound up with $35,000 in long-term gains and $10,000 in income. Suffice it to say that the client was pretty happy.

10. Taxes Get a Bad Rap

Like chess, the “game” of taxes can be fascinating. And once you start doing tax planning, you are likely to find it a rewarding process. Furthermore, what you are able to accomplish for a client’s tax situation will be rewarding to them. Many advisors can generate 8% to 10% per year for clients in investment returns, but wait until you report that you have saved them thousands of dollars in taxes because you have applied, say, the net-unrealized appreciation rule to a highly appreciated stock in a 401(k). The client’s satisfied smile will be the tip that you’ve done your job right.