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.