Tax Planning

Experts highlight the tax issues every financial adviser should know

Tax planning and the law of unintended consequences

Now is the time to examine the repercussions of your standardized versus customized advice

Feb 29, 2016 @ 11:40 am

By Tim Steffen

By this time of year, most taxpayers have begun preparing their income tax return, and many have even filed already. This becomes an interesting time for those who spend the year-end suggesting tax-planning strategies. Did the effort made to manage a tax liability actually work, or did the adviser and client miss something that negated the efforts? Did a well-intentioned tax plan have an unforeseen negative impact on another area of the return?

Advisers sometimes fall into the trap of recommending a standard set of strategies, without considering that every taxpayer's situation is unique. Each recommendation needs to be evaluated for its overall impact. No tax strategy should be viewed in a vacuum. In many cases, one activity can have a ripple effect across a tax return that can offset the intended benefit.

A simple example of this is recommending that a taxpayer pay his or her deductible expenses before year-end, rather than waiting until the next year. Doing this with things like property or state income taxes can end up pushing a taxpayer into the Alternative Minimum Tax, which eliminates the tax benefit of those expenses.


A more common example for advisers is around capital gains planning. For example, advisers may recommend low-income taxpayers (often retirees) realize enough in long-term capital gains to reach the top of the 15% tax bracket. In that case, the gains are not subject to tax. What may be missed, though, is that those gains are still part of a taxpayer's adjusted gross income. By increasing AGI, that retiree may find his or her Social Security benefits go from being tax-exempt to taxable. While the gain itself is not taxed, it will still result in a tax increase.

Those same retirees are likely to claim a deduction for medical expenses, which are only deductible to the extent they exceed a percentage of AGI. By increasing the taxpayer's AGI, even with untaxed capital gains, more of the medical expense deduction is lost. The same is true of miscellaneous itemized deductions, such as investment or tax-planning fees.

Another result of those gains is the impact on Medicare premiums, which increase at higher levels of income. Gains realized in 2015 will be considered when setting Medicare premiums for 2017, meaning the true cost of a capital gain may not be known until well after the tax return is filed.


Yet another example is recognizing capital losses at year-end in order to offset gains realized during the year. Suppose a taxpayer realizes a short-term gain during the year, and then sells a long-term holding for a loss at year-end to offset that gain — a perfectly allowable strategy.

However, the investor may also hold mutual funds that distribute gains to shareholders at year-end. Those distributions are always taxed as long-term gains — which in this case would offset the long-term loss that was realized, leaving the short-term gain fully taxable. A better strategy in that case would be to realize a short-term loss, which will be used against the short-term gain, leaving just the fund gains taxed.

For higher-income taxpayers, the risk is that additional income may trigger unexpected taxes or a loss of deductions. Consider the 3.8% Medicare tax on investment income. While an IRA distribution itself is not subject to that tax, it could be enough to push AGI over the $250,000 threshold for couples. That, in turn, triggers the tax on other investment income the taxpayer has. If the taxpayer is also subject to the phaseout of deductions, that IRA withdrawal is not only taxed, but also creates a loss of deductions — a double-tax whammy. This is something to consider when recommending a Roth conversion for higher-income taxpayers.

Lastly, advisers should remember that any strategy implemented now will have an offsetting effect at some time in the future, perhaps even the next year. A deduction or loss accelerated to this year is a deduction or loss that's not available next year — when maybe a higher tax rate would make those items more valuable. Tax-planning recommendations should be evaluated with a multi-year view, which typically requires advanced tax-planning software not available to most financial advisers. This illustrates why it's truly in our clients' best interests that investment advisers and tax planners work together.

Tim Steffen, CPA/PFS, CFP, CPWA, is director of financial planning for Robert W. Baird & Co. Follow him on Twitter @TimSteffenCPA.


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