Guiding Clients to Make Tax-Smart Decisions

By Ellen Sheng September 16, 2020

This is Part 3 of Financial Advisor IQ’s five-part special report on how financial advisors can help their clients manage the tax impacts of their portfolios.

It’s rare to find anyone who wants to pay more taxes than necessary. But sometimes it takes a bit of work to show clients how tax planning plays into their bigger financial picture.

“Some folks think just because they have a 1040 [tax return] and see their CPA [Certified Public Accountant] once a year that their tax situation isn’t complicated or that there is no benefit to working with an advisor on tax management,” says Ben Bremen, wealth advisor and certified financial planner at RMB Capital in Minneapolis.

Like many other advisors, Bremen reviews capital gains and losses, any carry-forwards, charitable giving, educational planning and other factors. He encourages clients to make tax-smart decisions by clearly laying out the benefits of the approach. Sometimes he uses financial modeling software to show that, by making certain changes, one can save a particular amount on taxes.

“Tax management [is] one of the most important aspects of someone’s financial planning. It’s not how much you earn but how much you keep after taxes,” Bremen says.

Tax planning is all-encompassing and should be discussed at every meeting. Advisors that are abreast of recent changes and mindful of potential changes in the future can provide tremendous value.

In today’s world, with robo-advisors and do-it-yourselfers, tax management is a valuable differentiating standpoint for advisors, Bremen adds.

Timely opportunities

This tumultuous year has led to some unique tax management opportunities. Market volatility in March and April made it a favorable time for tax-loss harvesting. The volatility also made it ideal for individual retirement account conversions by withdrawing depressed assets in traditional IRAs and paying taxes now, then moving assets to a Roth IRA, which can be withdrawn tax-free later. IRA conversions make sense for younger clients and those who are retired and want to pass on the money to the next generation.

For clients in the 24% or lower tax bracket, “Roth conversions are a no-brainer. Getting the tax out of the way is extremely attractive. Once you pay the conversion tax, if there is any, you won’t ever have to pay that again, nor will the kids or grandkids,” says Dean Mioli, director of investment planning at SEI.

There were also changes under the Coronavirus Aid, Relief, and Economic Security Act that made charitable giving in cash much more attractive. Usually, the maximum deduction for cash donations is up to 60% of adjusted gross income. This year, it’s 100%.

Combining Roth conversion with cash charitable donation can create a “tax savings powerhouse,” Mioli says.

For example, a client who goes ahead with a Roth conversion of $20,000 would find themselves with an additional $20,000 in taxable income. However, they could give a charitable cash donation of the same amount. The two transactions would in effect offset one another. One notable exception is that the cash donation must be donated directly to a charity, not a donor-advised fund.

Preparing for higher taxes ahead?

The upcoming presidential election also creates some uncertainty, not only in markets but also in tax planning. Income tax rates fluctuate depending on the political climate. Currently, they are at historical lows. Since 2017, married couples filing jointly with up to $326,000 in income can be in the 24% income tax bracket.

Accountants and advisors expect higher taxes ahead. U.S. debt to gross domestic product levels are nearing highs not seen since World War II and are projected to exceed the GDP.

“Covid is a very expensive proposition that we’re dealing with right now,” SEI’s Mioli says.

Though no one can predict the future, especially when it comes to tax changes, advisors can help prepare for various scenarios by diversifying. From a tax perspective, that means diversifying holdings in taxable, tax-deferred and tax-free accounts. Having all three buckets in place helps clients deal with any tax changes that come along.

Next: Ins and Outs of Tax Loss Harvesting