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Financial Planning > Tax Planning

How to Offer Tax Planning While Staying Compliant

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What You Need to Know

  • Financial advisors are often discouraged by their firms from talking too much about tax issues, given the potential for liability.
  • Clients are demanding such support, however, so advisors are seeking new ways to integrate tax considerations into the planning process.
  • Advisors should understand the differences between tax avoidance and tax optimization.

Almost every financial planning issue comes with tax considerations — whether it is retirement, investments, cash flow, insurance or estate planning.

Despite the prominent role of taxes in financial planning, advisors are often discouraged or outright prohibited by their compliance departments from making recommendations for a specific course of action on a certain tax strategy.

According to financial planning experts Jeff Levine and Michael Kitces, this cautiousness is warranted, given that most financial advisors are not licensed or qualified to provide what the duo refers to as “big T, big A, Tax Advice.”

This is the kind of advice that involves signing off on tax returns or approving a client’s claiming of specific nuanced deductions and credits. In other words, what a certified public accountant does.

However, according to Levine and Kitces, there is a lot of tax-oriented planning that does not involve tax advice as properly defined and policed by the Internal Revenue Service, and many firms fail to appreciate this fact. Instead, they create tax policies that are overly restrictive and based more on a fear of their people making mistakes than a belief in an outright legal prohibition against advisors talking about taxes.

Ultimately, Levine and Kitces warn, technology changes and other developments mean tax-savvy financial planning is becoming table stakes in today’s advisory industry, and firms that do not take pains to appreciate the important but potentially subtle differences between tax-aware planning and legally definable tax advice risk being left behind in an increasingly competitive landscape.

Advisors Needn’t Fear Tax Talks

The planning experts offered their perspective during the opening session of a digital tax-planning workshop put on by Holistiplan to help advisors get a handle on rapidly evolving issues at the intersection of financial planning and tax-aware investing.

As the pair emphasize, many advisors avoid talking about taxes for two reasons: First, they may not feel like they know enough about taxes, and second, they mistakenly believe they are legally prohibited from doing so.

Obviously, if an advisor doesn’t have a baseline level of expertise about tax-mitigation issues, they shouldn’t be making taxes a central part of their client deliverable. That said, many advisors do have a strong grounding in at least the basics of tax mitigation in the financial planning process, and in such cases, they may be shortchanging clients by not bringing this expertise to bear.

“The key thing to understand is that there is no blanket regulation against financial advisors making tax recommendations,” Levine points out. “Yes, the IRS states that only designated tax professionals like attorneys and CPAs can give advice on certain strategies, such as those that are designed to avoid taxation or which have a high potential for abusing tax laws.”

That said, many of the tax strategies that financial advisors recommend are not meant to shelter income to avoid taxation altogether. Instead, advisors’ work more often involves planning to ensure client assets are simply taxed more efficiently, such as by optimizing the timing or nature of income when it is taxed.

This effort can include anything from recommending Roth conversion strategies to helping clients structure required minimum distributions in a wise way.

“These are some of the most powerful strategies a good advisor can deliver for their retirement clients, and they clearly involve taxes,” Kitces explains. “From the IRS’ perspective, there is no requirement to be a designated tax professional in order to give advice on such strategies that optimize taxation.”

Avoidance vs. Optimization

During the discussion, Kitces and Levine urged listeners to read a detailed analysis published last year on by contributing researchers Ben Henry-Moreland and Steven Jarvis — particularly the section that details the critical difference between “tax avoidance” and “tax optimization.”

Simply put, advisors should avoid helping their clients with the former while ensuring their clients are accomplishing the latter.

Generally, “tax avoidance” strategies that tend to draw the IRS’ scrutiny are those that involve the creation of tax shelters or certain types of transactions that aim to permanently shield income from being taxed, for example by routing income through a foreign or tax-exempt entity.

As Kitces and Levine observe, these strategies might be legal by the letter of the law, but they often are designed to use gray areas and loopholes to stretch the rules beyond the intentions of those who created them. The IRS actually keeps lists of such strategies and requires tax advisors who recommend them to file disclosures.

Financial advisors who are not attorneys or CPAs generally should not get involved in this type of planning, according to Levine and Kitces. Doing so involves a substantial risk of inadvertently making prohibited recommendations.

The overwhelming majority of the tax-planning strategies considered by financial advisors are designed to achieve tax efficiency — not to avoid taxes entirely.

As Levine and Kitces explain, these types of strategies reflect what is stated in the IRS Taxpayer Bill of Rights: That everyone has the right to pay no more in tax than is legally owed.

“Advisors shouldn’t help their clients seek tax avoidance, but they should absolutely aim for tax optimization,” Levine says.

Firm-Based Restrictions

According to Kitces and Levine, unlike with “normal” investment advice, advisory firms are usually not required to create policies and procedures around properly given tax advice, unless they employ designated tax practitioners.

While this may seem like a fact that would ease concerns about tax discussions with clients, in fact the opposite is true.

“Traditionally, there has often been no clear-cut way to ensure tax advice is given correctly,” Kitces explains. “Because the consequences for incorrect tax advice can include legal and financial penalties if a client were to be harmed by the wrong advice, compliant departments have thus been hesitant and cautious.”

In some cases, firms may permit their advisors to engage in “tax planning” but not “tax advice.”

Tax planning, the duo explains, can range from giving general, nonspecific information on tax laws and regulations to creating detailed projections for clients and comparing the outcomes of potential tax strategies.

Again, the key is to avoid making recommendations of a specific course of action that would constitute tax advice allowed to be given by only a CPA or tax attorney. Generally, the more detailed the analysis, the more likely it could be construed by the client as a tax advice recommendation.

In these circumstances, safeguards such as upfront disclosures and collaboration with the client’s tax professional may be necessary to ensure that the tax professional — and not the advisor — is the one making the actual recommendation.

As Levine and Kitces emphasize, advisors should feel empowered to give investment advice that takes taxes into consideration. Ultimately, the question around tax planning isn’t whether it should be offered, but how it can be delivered to provide the most value to clients while protecting the client, advisor and firm.

The Role of Tech

According to Kitces and Levine, the emergence of tax-planning support software from the likes of Holistiplan and its peers and competitors has significantly changed the game for tech-savvy financial planners.

Such platforms not only help planners tease through the complex tax issues that cut across the retirement investment and spending process, they also automatically generate reporting and compliance documents that help ease the fears of compliance professionals.

“These platforms really speak to the compliance officer’s mindset,” Levine says. “Technology helps to set the guardrails and ensure the quality of advice, and it also answers the compliance question of how you oversee a large number of advisors who are doing this kind of work.”

(Image: Adobe Stock)


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