When I first set up my financial planning practice two years ago, I decided to obtain the Enrolled Agent designation from the IRS so that I could offer tax preparation services as a value add for my financial planning clients. What I have come to realize over these last two years is that combining these two services offer more value to my clients than I initially anticipated.
In most cases, financial advisors and CPAs (and other tax preparers) operate in isolation. Neither has visibility to what the other is doing. For the most part, when you give a CPA your tax information they will crank out an accurate return and do what they can to take acceptable deductions, keeping your tax bill as low as possible based on what you give them. But I am finding that CPAs rarely engage with their clients before year end to determine strategies that may be implemented in the upcoming year and beyond to lower their clients’ long-term tax rate. One issue is capacity. During tax season CPAs are swamped, working around the clock just to keep up with the flood of work. During the rest of the year they are typically keeping the books for their small business clients. The other issue is visibility. A CPA typically does not have visibility to a client’s long-term tax rate projection to know whether it would be better to take in (or push out) taxable income from the current year.
As for financial advisors, they tend to focus on the investment portfolio (maximizing the gross return) and don’t always think through tax implications. I have seen several instances where clients come in with tens of thousands of dollars of capital gains distributions from actively managed mutual funds that could have been avoided if those investments had been in passively managed index funds (which have much lower fees and are better investments even without the tax benefit).
Tax planning can lower the long-term effective tax rate in particular for those in their sixties who are retired or semi-retired but not yet collecting Social Security and taking required minimum distributions (RMDs) on their IRAs/401Ks. For those not familiar, the IRS requires that distributions from traditional IRAs/401Ks begin at age 70½. Those distributions are taxable and, combined with Social Security, can often push someone into a higher tax bracket than they were in during their sixties and living solely off their portfolio. The strategy here is to do Roth conversions during their sixties to “fill up” the lower tax bracket until their marginal tax rate crosses into the bracket they will be in during their seventies. When you do a Roth conversion (which just means moving money from a traditional IRA account to a Roth IRA account) you are taxed on the amount transferred, but once the money is in a Roth IRA it will not be taxed (including any earnings) when later withdrawn. This lowers the amount in the traditional IRA subject to the RMD. The most common situation is to pay taxes at 15% on the Roth conversion to avoid paying 25% later on the RMD.
This is just one example the benefits of combining tax planning with investment strategies. Another example is understanding the impact of the alternative minimum tax (AMT), especially in a year with a big bonus or stock option exercise. There are many others.
Effective long-term tax planning can make a big difference in the total amount of taxes you pay. I provide both tax and financial planning. With tax season approaching, if you think you could benefit from this type of integrated planning please reach out to me. I’d be happy to have a preliminary conversation.
Have a great 2016!