Some reflections on Tax Day: Tax strategies to take with your clients

Key Takeaways:

• Tax time can be a great time to touch base with your clients to discuss ideas on how they can improve their tax efficiency going forward
• Some conversation starters to ask your clients are “What was your tax bracket?”, “Did you get a refund?”, “Do you expect your total income to change this year?”, “How is your retirement plan working?” and more.

Another Tax Day is upon us. This year the filing deadline is Monday, April 18, as opposed to the usual April 15, due to the celebration of Emancipation Day in Washington DC. As a result, procrastinators will have an extra weekend to crunch their 2021 numbers. If that’s not enough extra time, taxpayers can also file an extension, which will give them until October 15 to submit their returns. Remember, however, that any taxes due are still payable by April 18, even if you request an extension.

Many financial professionals see tax time as a perfect time to touch base with their clients. With their tax returns fresh in their minds, many clients will be interested to hear ideas on how they can improve their tax efficiency going forward. In some cases, that might mean taking steps to reduce taxes, maybe by changing retirement plan contributions or upgrading a small business retirement plan. In others, it might mean taking better advantage of what is currently a relatively low tax environment.

Here are a few discussions worth having at tax time.

“What was your tax bracket?”

Every taxpayer should be aware of their federal income tax bracket. An easy way to estimate your bracket is to check your “taxable income” (Line 15 on Form 1040) and subtract any long-term capital gains (Line 7). Then you can check this tool to see which marginal tax bracket you fall into.

Knowing your top marginal tax bracket is important because it determines how your last “layer” of income for the year will be taxed, and this can have significant planning implications. For example, someone in the 24% marginal bracket should be aware that for every $1000 in tax-deferred retirement plan contributions they make, they’ll save $240 on their federal income tax liability. By contrast, every $1000 contributed on an after-tax basis to a designated Roth account will “cost” them $240 in federal income taxes. This is an important consideration when determining how they want to allocate their retirement plan contributions for the year.

Being aware of which bracket they fall into is also important for retirees. Retirees with a low amount of taxable income may find themselves in a relatively low 10% or 12% bracket. When this occurs, it can make sense to pull more money out of tax-deferred retirement accounts at these relatively low rates. Retirees who don’t need additional income may want to consider Roth conversions up to the end of their current bracket. This can allow them to build potentially tax-free retirement savings, reduce future Required Minimum Distributions, and leave an income tax-free legacy for beneficiaries.

“Did you get a refund?”

While people tend to love getting a big refund at tax time, this isn’t a very efficient way to pay taxes. It likely means that they have been having too much money withheld from their paycheck. One option is to reduce federal withholding. This can mean a bigger paycheck. But another option they may want to consider allocating more of their salary deferral to a designated Roth account. Because these contributions are made on an after-tax basis, they may not get that same refund next year, but their excess withholding can offset the additional taxes that can result from switching to Roth contributions.

“Do you expect your total income to change this year?”

There are many life events that can result in a change of income. Some clients might be taking time out of the work force to raise a child or care for an elderly parent. Some may be retiring. Some clients may be considering a sale of assets or property. Others might be inheriting assets.

When income is expected to change, other changes may help improve tax efficiency. For example, if a spouse leaves a job to raise a child, a couple’s income is likely to drop. The resulting change in tax bracket might make contributions to a designated Roth account more cost-effective. On the flip side, a client selling a rental property may expect to realize a substantial capital gain, which may also trigger the Net Investment Income Tax. The Net Investment Income Tax (NIIT) is an additional 3.8% tax that applies to investment income over certain thresholds ($200,000 for single filers and $250,000 for married couples filing a joint return). Increasing tax-deferred retirement plan contributions may not only keep someone in a lower marginal bracket, but it can also reduce Modified Adjusted Gross Income, which is used to determine exposure to the NIIT.

“Did you have to pay taxes on investment income?”

Clients with assets in non-qualified brokerage accounts can get hit with income from dividends, long and short-term capital gains, bond income, and mutual fund distributions. While long-term capital gains and dividends benefit from long-term capital gains tax treatment, investment income can nevertheless add to a client’s tax bill for the year. As an alternative, a variable annuity can offer the ability to invest in equity and fixed income markets with the added benefit of tax deferral. This can be particularly beneficial for clients with NIIT exposure.

“How is your retirement plan working?”

This is a good question for small business owners. There are several small business retirement plan options available, from SEP IRAs to SIMPLE IRAs to qualified plans such as profit sharing or 401(k)s. Each plan has advantages and disadvantages. Those issues should be fresh in the mind of business owners who have just filed their returns.

A possible follow-up question might be “were you happy with the amount that you were able to contribute for yourself and your employees?” Small business owners with a SEP IRA might be happy with their contribution but could be concerned about having to make relatively large contributions for their employees. On the other hand, business owners with a SIMPLE IRA might appreciate the relatively small contributions for employees but could be frustrated about not being able to make a larger contribution for themselves. Either of these concerns could open the door to a conversation about upgrading their current retirement plan. A qualified plan, such as a profit-sharing plan with a 401(k) salary deferral option can be designed to maximize contributions for the business owner, minimize contributions for employees, and add a Roth option for salary deferral.

When it comes to retirement plans, keep in mind that while tax time is a good time to have this conversation, it’s also important to make business owners aware of certain deadlines. That’s because to put a qualified plan in place for the current tax year, the documentation must be filed by December 31. A SIMPLE IRA must be established by October 1 to be funded for the current tax year. These deadlines can come as a surprise to business owners who are used to having until the tax filing deadline plus extensions to establish and fund a SEP IRA.

“Would you be comfortable providing me with a copy of your return?”

Having a copy of a client’s tax return can be helpful as you prepare for client reviews. It can also help you understand the client’s likely tax bracket, which can be an important factor in investment selection. Finally, it demonstrates to the client that you are fully considering their overall financial picture in your recommendations.

Here’s to wishing everyone a happy and productive Tax Day this year!