Considering the tax increases we’ve witnessed during the past six years, it’s no surprise that millions of Americans are very concerned about the direction of tax policy, including your clients.
So why is reviewing your clients’ tax returns important? After all, most clients have a CPA and it’s their job to provide tax advice and prepare tax returns. I’m not suggesting an advisor should replace the CPA, but an advisor who is familiar with this part of the tax code may have a stronger value proposition and appeal to the higher-net-worth client. At the very least, the ability to identify tax benefits or problems may place an advisor in a better position to serve as team coordinator for clients with multiple advisors. Finally, looking at your clients’ tax returns may also yield some opportunities for you to show your specific value while benefiting the client’s tax bottom line.
In this article, the first in a three-part series, we’ll look Under the Hood of IRS Form 1040, examining several types of income and discuss a few relevant issues that apply when advising clients.
Income Items (lines 7-22)
Line 8a: Taxable Interest
Does the client have a large amount of taxable interest? Are they in a high tax bracket? If the answer to both questions is yes, consider replacing some of their taxable investments with tax-exempt vehicles. Before doing this you should calculate the client’s tax-equivalent yield to see if a tax-exempt investment is warranted.
Form: 1099-INT or 1099-OID
Note: Schedule B is required if the total amount of interest is above $1,500 or if any of the conditions at the beginning of Schedule B apply.
Line 8b: Tax-Exempt Interest
If the client has tax-exempt interest and the figure on line 8b is substantial, check their alternative minimum tax (AMT) status (Form 1040 – line 45). Why? Because tax-exempt interest from private-activity municipal bonds is a tax preference item for purposes of the AMT. If they are subject to the AMT and this type of interest is a factor, it may be prudent to replace these particular bonds.
Form: 1099-INT or 1099-DIV
Line 9b: Qualified Dividends
Ordinary dividends are taxed as ordinary income. Qualified dividends are taxed at the client’s capital gains rate which will be 20%, 15% or 0%. For more details on long-term capital gains rates, see Line 13 below.
Line 11: Alimony Received
If a client is receiving alimony, they must provide their Social Security number to the person who is making the payments. Failure to comply may result in a penalty. Alimony offers a potential planning opportunity. To explain, consider the following example. Assume the ex-husband is in a low tax bracket and is paying $12,000 per year in alimony. After receiving an income tax deduction for the alimony payments, his cost after taxes is $10,200. The ex-wife must claim the alimony she receives as income. After paying the tax due, her net amount would be $7,800 per year. (See table below).
In lieu of the regular payments, if the ex-husband purchased an annuity to provide the ex-wife’s income, and the cost of it was less than the NPV of his after-tax payments (i.e., $144,967), and if the annuity paid her more than she currently receives (i.e., greater than $7,800 annually after tax), both parties would benefit.
An alternative to this would be for the ex-husband to give the ex-wife a lump sum that is greater than her after-tax NPV (i.e. $110,857), but less than his NPV amount (i.e. $144,967). Of course, any arrangement such as this would need the approval of the court. If all parties agree, it would reduce the husband’s outlay and increase the amount the ex-wife receives. If it isn’t structured as alimony, the gift tax may come into play. However, this could easily be remedied with the client’s lifetime gift tax exemption.
Line 12: Business Income