A critical part of any comprehensive financial planning engagement is tax planning. As such, we review a lot of tax returns every year. We see some issues or mistakes on a regular basis.

The tax code is complex and there are many “if this, then that” situations to navigate. Good software helps but software is only as good as its design and its user. A self-preparer that has an inadequate understanding of the rules, doesn’t use software that tracks these things or uses good software inadequately can easily stumble.

When people use a paid preparer, the issue is often communication. Many of these issues can be avoided through better communication, particularly when people start to use a paid tax preparer or change preparers. Commonly, either the preparer doesn’t ask about an item or more often, the client fails to provide the information requested.

With tax season upon us, I thought I’d list some of the recurring things we see so planners can help their clients avoid paying more than required.

Carrying Forward A Carryforward

The most common way we see carryforwards treated improperly is failing to carry forward a capital loss carryforward the taxpayer could use. This is usually because of a change in software or a change in preparer. In the transition, the fact that the carryforward exists gets lost.

The other carryforward error is carrying forward beyond its allowed use. For instance, charitable carryforwards can only be used up to 5 years after the donations. I’ve also seen a taxpayer who could not itemize his deductions report his donations on Schedule A of the following year. His understanding of what a carryforward is was simply incorrect. He thought that because he couldn’t use the deduction in the year the donation was made, he could carry it forward to the next year.

High Bracket Clients With High Percentage Of Non-Qual Dividends Or Taxable Interest

Often clients are not aware that non-qualified dividends are taxed at higher rates than qualified dividends or they aren’t aware of what holdings generate non-qualified dividends. REITS, foreign stocks and preferred stocks are often in this category. In many cases, by being more tax aware and employing some tax sensitive asset location, we can reduce a high-income client’s tax bill in a sensible manner.

In one case, a new client had all his fixed income holdings in corporate bonds. When we broached the subject of using tax-free municipals instead, he expressed grave concern. A conversation about credit quality ensued and he realized that not all muni bonds are like those of Puerto Rico. The news about that mess is what scared him. Today, the high-quality munis in his portfolio are generating more net income and providing more stability than the taxable holdings he had originally.

Using Zero Basis For Non-Covered Securities

The law says that preparers must rely on reports from custodians when reporting portfolio gains and losses on “covered” securities. When a security isn’t covered, the custodian will typically place an asterisk next to the item on the report and use what basis was provided to them or a zero. For most folks, few securities have zero basis. They may not know what the basis is, but it is usually not zero.

In a common scenario, the preparer first sees the zero basis when the tax reports arrive. They do not have the time to research it. The tax preparation agreement states the preparer is relying on the information provided. If they point out the issue, they ask the client to get a basis for them. The client doesn’t have a clue or thinks they can’t get a basis.  When the client expresses a much greater sense of urgency to get the taxes filed than to do any digging, the preparer says, “No problem. We can always amend when you find it.” No one ever researches the basis and the clients pay taxes on an inflated gain.

We’ve made a lot of new clients very happy by doing some digging. Yes, sometimes the work is maddening, but sometimes it is simple.

Large Cap Gain Distributions

When we see large capital gain distributions from mutual funds, it is often another sign of a lack of awareness about portfolio taxation and construction. By the nature of how they are managed, some funds are far more likely to kick out capital gain distributions than others. There may be an asset location decision to be made about what types of holdings to use in the various types of accounts.

There is also an attention to detail angle here. Were the funds that paid the large distributions bought recently? What would the tax have been had the fund been sold prior to the record date? Was a chance to lessen the tax bite ignored? Did anyone even look?

Contributions To Traditional Or Roth IRAs

Deciding not to contribute to an IRA is one thing. Failing to contribute because one erroneously thinks they are prohibited from doing so is another.

Every taxpayer with earned income is eligible to contribute to an IRA of some sort. The issue is only whether they can get a deduction or not. The rules about this are a bit messy but worth attention.

Common misunderstandings we see include:

“I can’t contribute to an IRA or Roth because I have a 401(k).”  (Not an issue)

“We can’t contribute to my spouse’s IRA/Roth because he doesn’t work.” (Contribution limits are based on joint income not per taxpayer.)

“I didn’t contribute to my IRA because I made too much to deduct.” (Was a non-deductible contribution or a Roth contribution or a “back-door” Roth considered?)

“I didn’t contribute because my deduction was limited.” (It is permissible to take a partial deduction.)

“I didn’t contribute because of the pro-rata rule.” (The pro-rata rule applies to distributions not contributions, and with some planning, it may not be an issue.)

We also see many taxpayers that don’t take advantage of catch-up contributions.

Paying Tax Twice

Speaking of non-deductible contributions to IRAs. Whenever I see an IRA distribution which is reported as fully taxable, I always ask, “Do you recall any time you made a contribution to your IRA and did not deduct that amount from your taxes?” In many cases, my asking prompts them to remember that they had indeed made non-deductible contributions.  A hunt for the records ensues and we are often able to amend returns and get some money refunded.

Missing QCDs

Qualified charitable distributions (QCD) are easy to miss. Clients often assume that the custodian accounts for QCDs but they do not. Responsibility for proper reporting is the taxpayers. Typically, the 1009-R comes out reporting the gross distribution, the client doesn’t even think about it and doesn’t tell the preparer about the donations. The preparer then reports the full gross amount and the client pays tax on too much income.

Sometimes the client informs the preparer that they made a donation but fails to tell them the donation was made from the IRA. The preparer then puts it on Schedule A. This results in an improper treatment of the donation or can be completely forgotten because the client doesn’t even itemize and uses the standard deduction.

The last scenario occurs when the taxpayer makes donations early in the year and forgets about them. This is common with small donations and when many donations are made throughout the year. Each IRA owner over 70 ½ can donate up to $100,000 per year. Most people won’t forget a $100,000 donation but many will forget a $100 gift.

The amount of taxes clients will pay in their lifetimes typically dwarfs their financial planning or investment fees. It takes some effort on our part but minimizing tax costs in sensible ways can make a huge difference for clients.

Dan Moisand, CFP, has been featured as one of America’s top independent financial advisors by Financial Planning, Financial Advisor, Investment Advisor, Investment News, Journal of Financial Planning, Accounting Today, Research, Wealth Manager, and Worth magazines. He practices in Melbourne, Fla. You can reach him at [email protected].