Taxpayers may see the familiar Form 1099 as just another document to ship to their accountant. But as Morningstar's personal finance and retirement planning director, Christine Benz, recently wrote, the versions that come from financial firms — Forms 1099-DIV and 1099-INT — can provide key information to help improve client portfolios.
"The 1099s are a valuable clue to asset location issues," she said.
Benz recently spoke with ThinkAdvisor about clues advisors can take from tax forms to help optimize client portfolios, and the moves they might consider.
"I think increasingly advisors are seeing this as a way to add some value for their clients. So there's not necessarily a CPA who the person has to contract with separately," she said. "The advisor is doing this work for them."
Dividends and Capital Gains
Form 1099-DIV reports qualified and nonqualified dividends, along with capital gains distributions.
Clients heavy on nonqualified dividends — which are taxed as ordinary income — in taxable accounts might do better to put such holdings in tax-sheltered accounts, Benz suggested, adding that taxpayers who reinvest qualified dividends also might sidestep annual taxes on distributions by placing those assets in tax-sheltered vehicles.
High-yield bonds and real estate investment trusts are classic examples of investments with distributions that may be taxed as ordinary income, she noted.
"That's a red flag to see if you can't maybe find some room in the tax-sheltered portfolio," she said.
Another example is equity mutual funds with capital gains distributions.
"This is a really common scenario because we've seen an exodus from actively managed mutual funds into low-cost index funds and ETFs," Benz said, "and the net effect of that has been kind of a really terrible cycle for taxable shareholders" when their funds have redemptions.
"The managers are having to sell to meet the redemptions and then that creates a taxable distribution for people who stick around," she said.
Morningstar looks at a fund's "tax cost ratio," she said. This figure is similar to an expense ratio, but instead of measuring the impact of fees on returns, it measures the bite taken out of returns by taxes on distributions. Some active funds have tax cost ratios exceeding 2%, compared with a typical ratio under 0.5% for an index fund, said Benz.
"It adds up," she said, noting that holding these types of investments in a tax-protected IRA makes these distributions a nonissue.
But What About Tax Loss Harvesting?
With the stock market up, there aren't many tax-loss-harvesting candidates sitting around waiting to be sold, she noted.
"It's been an issue and it's been a reason why I would caution investors against putting any actively managed funds in their taxable portfolio. It's just sort of a wild card that you can nicely control with using index funds or ETFs."
A Tricky Fix
Correcting a tax-unfriendly asset arrangement isn't always easy, Benz noted.
"People oftentimes start assembling portfolios before they're really conversant in tax matters, so some of these things can be very hard to undo," she said.
"Say you have a serial capital gains distributor, one of these funds that has had big redemptions and made a series of large capital gains distributions year after year. The person's cost basis might still be pretty low in that position," she explained.
"Fixing that isn't that easy. Selling it and getting into a tax-efficient ETF isn't necessarily the best move because selling the serial capital gains distributor is going to trigger its own tax cost to make that fix," she said.
Another tricky issue, according to Benz: Often clients want the liquid component of their portfolio, which is usually the income-generating portion, to be accessible rather than siloed in their retirement accounts. But for clients with lots of income-producing assets, she said, it's a conversation worth having.
Maximizing Interest Income
A 1099-INT can indicate whether a client could be earning more on their assets. If the form shows piddling amounts of income on a large account balance, "that's a great flag for an advisor to recognize," Benz said.
Paying less than market rates for cash accounts and pocketing the spread is a big moneymaker for many asset managers, she noted. (In her article, Benz notes that assets earning under $10 won't even trigger a 1099.)
"So that's a good opportunity for advisors to add value for their clients, to spot some of those things," she said. "Like, 'Hey, we've got $30,000 here in a cash account, and I see that you got $18 in interest last year. What can we get the money into so that it's working a little harder for you?'"
These cash accounts might not even be in the mix that the advisor is actively managing, "but it seems like a nice value-add to point out … 'we can get 3.5% over here on that money.'"
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