How to Talk About Taxes with Your Financial Planning Clients

Income tax law changes frequently. While tax law is not usually as volatile as the stock market (thank goodness), it’s still convoluted and difficult to navigate, making it the perfect topic to discuss with your clients, who, like most other people, probably feel like they’re shooting in the dark when it comes to their taxes.

This is especially true this year as we saw several tax law changes in response to COVID-19; filing and payment due dates were extended, stimulus money was distributed, and the Paycheck Protection Program (PPP) and Economic Injury Disaster Loan (EIDL) were announced. In 2020, we also saw the elimination of most required minimum distributions (RMS), and the ability to repay those RMSs already taken was changed back to January 1.

Remember back to your high school government class. US laws—including taxation—are created through compromise in Congress, then applied by the executive branch, and interpreted by the judicial branch. During the compromise phase, legislators negotiate the benefits and burdens of each law—when the law is finally passed, someone inevitably wins and consequently, someone else loses. The result is a tax landscape that is confusing to navigate and filled with limitations, some with phase outs, and some with tax cliffs.

Sometimes a client can decide the relative benefits between multiple tax laws. Therein lies the benefit of planning for taxes by bringing certainty to the financial planning process while taking advantage of the benefits and avoiding the tax cliffs.

A tax cliff occurs when a deduction, credit, or tax increase occurs at a specific amount of income. Instead of phasing in or out the way a gradual tax does, cliffs incur changes to your tax liability immediately upon reaching a certain income threshold. There are several tax cliffs in the federal code. For example, the Earned Income Tax Credit (EITC) is a refundable income tax credit designed to help lift people out of poverty.

For most people, it phases out as income increases to the point where someone becomes completely ineligible once they meaningfully exceed the federal poverty level. However, the EITC also contains a provision that makes someone totally ineligible if they have more than $3,600 of investment income. At $3,600 of investment income, your client can qualify for the full EITC. At $3,601 your client has gone over the cliff and doesn’t qualify at all.

The tuition and fees deduction works in a similar way. This allows your client to deduct several thousand dollars of educational expenses if your client, spouse, or dependents were students during the year. However, this deduction only applies to filers who earn $80,000 or less ($160,000 if filing jointly). At $80,000 of income, your client can claim a tax deduction worth up to $2,000. At $80,001 your client can’t claim anything at all.

Here’s a real-life example: several years ago, I was preparing a tax return for a hair stylist who operated a salon and rented out a booth to another stylist. The prior tax return was set up to show a rental activity for the booth rent as the taxpayer knew rental activities were not subject to self-employment taxes. However, this taxpayer had consistent low income and the booth rental was high enough to eliminate any benefit for the Earned Income Tax Credit. We changed the returns to show the booth rental as part of her business income, and she qualified for the EITC that more than made up for the small increase in self-employment tax.

There are opportunities to help your clients more strategically approach their taxes at almost every turn. Let’s look at some of the different clients advisors work with, their tax situations, and opportunities to discuss different aspects of taxation with them.

The Young Client

Young clients are building their careers or their businesses and their income is largely in the form of wages or business profits. They may have student loans they are still paying off (or may even still be completing their college years). Their income rates are generally low.

These clients have a long working life ahead of them, so making Roth contributions (direct or back door) is a great recommendation. The combination of low tax rates now with a long future of compounding tax free earnings is hard to beat.

These are also the clients who are getting married and starting families. These life changes are a good time to remind your clients to update their W-4s so the right amount of taxes are withheld. From a tax perspective, getting married at the end of the year often results in a large tax due if both clients worked during the year and had similar income. This is because their incomes are combined for the many thresholds and limitations. While congratulating your clients on their upcoming marriage, you should also recommend they consider what a jointly filed tax return will look like and plan accordingly.

With the increased standard deduction under the Tax Cuts and Jobs Act, most of these clients are taking the standard deduction unless they have a mortgage on their homes. Just buying a home during the year may not be enough to itemize as the interest and property taxes paid might not be high enough the first year. These first mortgages have a new limitation—interest on more than $750,000 balance is not deductible. Also be wary of any really creative financing lenders offer with multiple loans that may not be secured to the home. Only mortgages that have the residence as security for the loan can be deducted as mortgage interest.

The Middle Age Client

Middle age clients are ones with established carriers and who are accumulating wealth. These clients are generally in the higher tax brackets and are concerned with keeping more of their earnings. These clients also often have aging parents and may therefore be inheriting wealth.

It’s important to recognize that the IRS taxes the deceased person if their estate is large enough, but generally not the beneficiary on transfer of assets. States are different story; as of 2020, Iowa, Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania collect an inheritance tax. There are also a number of states have their own estate tax laws. While helping your clients through the grieving process of losing family and dealing with estate management, offer to help them with the estate and inheritance tax aspects as well.

Maximizing contributions to retirement plans is a good course of action for these clients, even though they will generally have less time before retirement for the contributions to reinvest. Should these clients have a really bad tax year, take advantage of the low income rates to do a Roth conversion.

For the solo business owner clients in this group, the opportunities to contribute wealth into retirement plans can be amazing. For example, a solo 401(k) plan can contribute a $19,000 salary deferral and up to a 25% salary match for a combined $56,000 funding in 2020. For the really profitable, consider additional plans like cash balance or defined benefit plan.

Clients in this group have the wealth to contribute to 529 plans to save for their children’s educations. Many states allow a deduction for contributions to these plans, but be aware the opportunity to maximize the deduction by having one or both spouses open an account for each child. Each state has their own nuances.

These clients are upgrading their primary residence and vacation home to suit their lifestyle. Be aware that interest on mortgages originating after December 2018 are limited to a $750,000 balance. Home equity lines of credit are no longer deductible. Also take into account that the IRS considers anything that has sleeping, food preparation, and bathroom facilities a home. Therefore some recreational vehicles like motor homes and boats could lead to a mortgage interest deduction if below the loan limit.

In many cases, kids who go off to college are still claimed as dependents of their parents. This cause some oddities with the stimulus payments this year. Some students who had filed their returns even declaring they were dependents of others (and not eligible to receive the stimulus) received the stimulus, yet others in the same situation did not. In these instances, remind the clients and their children that the April stimulus payment was an advance on their 2020 tax return, and a reconciliation will be made. If students will be claiming themselves in 2020, they will get the stimulus when they file. If they received too much stimulus, or were not eligible, they may have to repay it. Although a second stimulus payment is in the works, until the bill is officially signed into law, I would not hazard a guess on who is eligible and how much to expect to receive.

The Elderly and Retired Clients

These clients have accumulated their wealth and are stretching it through their retirement as well as planning to transfer what’s left to their heirs. They are often downsizing their homes and could benefit from knowing the tax exclusion of gain if they meet the ownership and use requirements.

These clients also sometimes have to deal with the loss of a spouse. As you guide them through the grieving process, keep in mind that the deceased spouse’s assets get adjusted by step up or step down to date of death value. If the clients are in a community property state and hold the assets jointly, then both spouses get an adjustment to basis. Sometimes the terminally ill want to organize their affairs and gift or sell assets to simplify their estates. You can really shine in this situation by recommending they sell assets in a loss position to capture the losses, but hold the assets with unrealized gain for step up. For many, this would be a good time to form or update family trusts to hold the assets and help with estate management.

Let’s take a look at another real-life example. Years ago, a tax client in this situation had several rental properties they were interested in selling. The real estate agent pressured them to sell quickly as it would be more work for the agent as well as title and escrow if the terminally ill spouse passed before transfer occurred. These assets had low basis and were held in a community property state. One of the properties closed and it resulted in a needless and very large taxable gain. I wish the real estate agent would have realized the issue as the sale commission would not have changed, but their view of him sure did when we told the surviving client how much tax he had to pay on the sale that closed quickly. Because financial advisors often have closer relationships than tax preparers, you have the chance to prevent unfortunate situations like this from reoccurring.

Unfortunately, elderly and retirement clients are often a target for embezzlement or fraudulent schemes like fake tax notices, tax collection calls, or requests for money from grandchildren. Please have your clients share any tax notices or odd requests they receive before paying anything to verify they are authentic, and have a tax preparer or legal counsel step in to help deal with tax collection calls as its almost impossible to get any money back once transferred.

No matter what category your clients are in, there are opportunities to discuss tax aspects of their unique financial situations and help protect their assets. With practice, discussing taxation will become a natural and comfortable outgrowth of your current client relationships and will help you build deeper, more trusting relationships. You don’t need to be a tax expert to have these conversations. You can and should use your network of knowledgeable professionals to help your clients understand their financial situations and take advantage of their opportunities.

About the Author
Michael Law, CPA, is a Senior Tax Manager for XY Tax Solutions, a wholly-owned subsidiary of XYPN offering an outsourced tax team for XYPN members. Michael has 22 years of experience including time spent as Vice President of Tax Operations at Goldman Sachs. Other hats he has worn throughout his career include Supervising Senior Accountant, Tax Manager, Audit Manager, and Tax Partner.

He's been published or quoted in Accounting Today, Small Biz Daily, Business News Daily, and more. Michael holds a Masters of Science in Taxation from Golden Gate University and a Bachelor of Science in Business Administration from California State University.