8 key do's and don'ts for advisors and their clients as Tax Day approaches

April 12, 2023 10:14 PM

With just one weekend to go before most tax returns are due, more than 90 million Americans have already filed their forms and claimed $183 billion in refunds — leaving nearly half still to cross the looming Tuesday, April 18, deadline.

"File ASAP. Don't wait until the last day," said Thomas F. Scanlon, an advisor at Raymond James in Manchester, Connecticut.

The reason, he said: The Internal Revenue Service's electronic filing system "backs up and sometimes returns get rejected for odd reasons."

At $2,970, the average direct deposit refund as of March 31 was 10% smaller than last season's $3,304, the most recent IRS data shows. Blame the end of 2022's pandemic stimulus money that boosted child tax credits and last year's lousy stock and bond markets, which socked many investors with taxable distributions from money-losing funds.

Taxpayers in flood disaster zones in most of California and parts of Alabama and Georgia hit by mudslides and other bad weather have until Oct. 16 to file their returns.

Meanwhile, many of roughly 76 million Americans have until midnight next Tuesday to hit the send button (or, far less commonly, postmark a snail mail paper return).

Here are some last-minute do's and don'ts that can save advisors and clients stress and potentially lower a tax bill.

DO answer all questions on the 1040

The federal return covers all income in 2022 and associated credits and deductions that will be taken for that year.

Skipping over entries can cause the IRS to delay processing and any refund. Be sure to answer the question at the top of the form about digital assets, which sits right below basic details like filing status, name, address and social security number.

This year, the crypto question is phrased differently.

For returns being filed now, the query is: "At any time during 2022, did you: (a) receive (as a reward, award or payment for property or services); or (b) sell, exchange, gift or otherwise dispose of a digital asset (or a financial interest in a digital asset)?" By contrast, returns filed last year asked, "At any time in 2021, did you receive, sell, exchange, or otherwise dispose of financial interest in any virtual currency?"

Digital assets include cryptocurrencies such as bitcoin, stablecoins pegged to a national currency and nonfungible tokens, those digital artworks by artists like Beeple that sell at auction for tens of millions of dollars.

"Please do not answer 'no' if you are trading in digital assets, because the IRS already knows," said Larry Pon, a certified public accountant in Redwood City, California, referring to crypto exchanges that send documents detailing transactions to the agency.

DO consider whether an amended return is necessary

Even if a return is already filed, one may not be in the clear.

After a series of flip-flops just weeks after the filing season opened on Jan. 23, the IRS said April 11 that potentially millions of taxpayers who already filed their returns for this year and reported state tax refunds they received in 2022 as taxable income should consider filing an amended return.

In early February, the tax agency said it hadn't yet decided whether state tax rebates and refunds were taxable. Then one week later it said that they weren't taxable. The issue is that many taxpayers had already raced to submit their returns — heeding the perennial "file early" advice — in hopes of avoiding the mammoth processing backlogs and delays that plagued the prior two seasons.

The upshot is that filing an amended returns is in the cards for at least some of 75 million taxpayers in affected states including California, Colorado, Illinois and Virginia.

DO top up certain retirement accounts

The time to kick in extra dollars to a 401(k) for last year ended Dec. 31.

But taxpayers have until April 18 to make contributions to their individual retirement accounts, both traditional and Roth — and, for traditional IRAs, to potentially take deductions for 2022. One can kick in $6,000, plus an extra $1,000 for those aged 50 or older. Those are the IRS's limits for last year, so they apply to returns now being filed in 2023.

The rules on who can claim a deduction are limited by income levels and whether a person or household owns other retirement plans. The IRS calculates those income levels as modified adjusted gross income, which is taxable income, like salaries, minus deductions for retirement plan contributions, alimony and half of any self-employment taxes paid.

If an individual, or an individual and a spouse, don't have an employer-sponsored retirement plan such as a 401(k), they can deduct the full contribution from taxes right now.

By contrast, a single filer who also owns a 401(k) can deduct her IRA contribution in full only if her MAGI is $68,000 or less. For married couples, the limit is $109,000. The deduction phases out and disappears completely if a single filer made at least $78,000 last year (for married filers, the threshold is $129,000).

Contributions to Roths aren't deductible, but gains pulled out after someone is at least 59½ and had the account for five years are tax-free.

DO know what the deadline is for a Roth conversion

Kicking dollars into an IRA in the remaining hours before Tax Day, then converting that plan to a Roth, doesn't mean one owes taxes by April 18 (or Oct. 16, if filing for a six-month extension or one is in a weather disaster zone) on the conversion.

That's because the deadline for Roth conversions is Dec. 31 each year. So a switch tomorrow, even with an IRA topped up days before the filing deadline, won't bear a tax bill until the next returns are filed in 2024.

As America ages, millions of savers who have left or will soon leave the workforce face lower tax bills in retirement.

"Many Americans are experiencing a declining tax bill," said Steve Wittenberg, the director of legacy planning at SEI Investments in Oaks, Pennsylvania. "As such, this gives them the opportunity to save more for retirement or future goals," especially as the current historically low individual rates and high gift and estate tax exemption levels are set to rise come 2026.

"If you expect not to need IRA distributions during your lifetime, a conversion to a Roth IRA will avoid required minimum distributions at age 72½, allowing your children to inherit the IRA and stretch distributions for their life span," Wittenberg said.

Read more: College savings plan money left over? Hello, tax-free Roth

Read more: Year-end tax strategies acquire a twist

DON'T overpay taxes on Treasury bonds

The two-year Treasury yield is at the highest level since 2008. — The U.S. Treasury stands in Washington, D.C., U.S., on Wednesday, Nov. 8, 2017. Federal Reserve Chair Janet Yellen hasn't yet decided whether she'll stay at the central bank in a diminished role when her term as chair ends in February, Treasury Secretary Steven Mnuchin said in an interview today. Photographer: Andrew Harrer/Bloomberg

Interest income from U.S.Treasury bills, notes and bonds is subject to federal income tax but exempt from state and local income taxes. That's especially important for investors in high-tax states like California, where the top rate is 13.3% for those with $1 million or more in taxable income.

So if one had $1 million in U.S. Treasury-only mutual or exchange-traded funds that earned 3% in 2022, she has $30,000 in interest income to report on her federal return.

Jim Colavita, a managing director at GenTrust, a registered investment advisory firm in Miami, said that some taxpayers — or, rather, their financial advisors — mistakenly assume that interest is taxed by the state where they live. Make that mistake in the example above, and one could end up inadvertently paying $3,990 to the state of California.

Avoiding the error is not as easy as it seems, especially when a fund contains a mix of T-bills and stocks. Colavita said many of the 1099 forms that brokerages send to an investor, with a copy to the IRS, don't highlight interest income from ETFs or mutual funds that hold Treasuries along with other securities.

"The accountant is left to scour line by line the individual holdings of ETFs and funds to filter for Treasury assets," he said. "Your advisor should highlight this potential shortfall in the 1099s to insure you do not overpay on your taxes."

DO have a handle on 1099s

These documents are the Rosetta Stone of investment income and freelance gig work. And they come in many forms.

A 1099-DIV shows one's dividends and capital gains on taxable investments, like a brokerage account or mutual funds. A 1099-INT shows interest income received on investment. A 1099-B captures capital gains or losses realized — meaning the investor sold securities last year — in taxable accounts. Morningstar says that while some brokerage and fund companies smoosh all that information into a single form, others do not.

Gig workers, independent contractors, freelancers and owners of small businesses typically get a 1099-MISC documenting the income they received last year from work or business operations.

The forms for investment income can be a major clue about how efficiently one is putting dollars to work in the stock and bond markets.

"If you received many 1099s from different providers, that could be a signal that your portfolio is "busier" than it needs to be," Morningstar's director of personal finance, Christine Benz, wrote in a note earlier this year. "Is there a way to consolidate your accounts with a single provider or two, rather than maintaining a lot of 'onesie' accounts? If so, consider streamlining."

A form known as 1099-K was supposed to come into effect this year but has been pushed back to returns filed next year for 2023's income. Still, get ready now.

The form, a copy of which goes to the IRS, details a taxpayer's transactions involving payment cards and third-party networks. And it will require details for all transactions on platforms such as eBay, PayPal, Venmo, Etsy and Airbnb collectively totaling at least $600. The prior threshold was $20,000.

The IRS issued a frequently-asked questions list, with answers, in March.

Read more: What the wealthy can fear from a new IRS rule on $600 payments

DON'T annoy financial advisors and accountants

With days to go before filing day, return preparers are working around the clock. They're inundated. They're tired. Their ranks are shrinking. And many clients, both existing and potential, don't make things easier.

Dan Herron, a wealth advisor, accountant and the founder of Elemental Wealth Advisors in San Luis Obispo, California, said that "the top thing that drives us crazy" is prospective clients who are aggressive and rude. He cited a woman who called his office earlier this week and was outraged to hear there was a waiting list for new clients.

"She was so rude, and yelled, 'well, you should know that California flood victims have until Oct. 16 to file!' Um, we know that, and you're not helping your cause," Herron said.

Next on Herron's list is clients who don't provide the forms needed to complete a return, like a mortgage interest statement or 1099 from a brokerage.

"When we request information and you say that we already have it, it's frustrating because we wouldn't be asking you for it if we did have it," he said.

People who call or email daily to see if their returns are done are also annoying, he added, "especially those who drop it off one day and then the very next day ask for an update."

Then there are the people who got organized early but fail to cross the finish line.

"I have like 40-50 returns just waiting for sign offs. Some of those go back to Feb.," tweeted Brian Borawski, an accountant in Waterford Township, Michigan, on Thursday.

DON'T cheat

Herron of Elemental Wealth Advisors said some taxpayers want to take sketchy deductions based on so-called advice they read on forums like Reddit. He cited a client who wanted to deduct her personal therapy sessions with a psychologist, arguing that the visits had a business purpose that allowed her to improve as a medical professional.

"Um, no," he said.

Said Pon: "Do not lie or cheat. It is very easy to catch a lie. Why bother? The consequences are bad. I notice cheaters do not save that much money anyway but expose themselves to much more risk. If you understate your income or overstate your deductions, the IRS can impose very stringent penalties that can easily double your overall bill."