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When advisors have to break bad tax news

In the wake of last year’s well-publicized federal tax cut, many clients expected bigger refunds and lower tax bills this spring. Some have gotten their wish — but others have seen their refunds dwindle or replaced by unexpected bills. Now, many advisors are finding themselves the bearers of bad news.

The W-2 employees among his clients were particularly vulnerable to this unpleasant surprise, says Seth Corkin, a planner at Boston’s Single Point Partners. “Their refunds or amounts owed have been pretty consistent, but this has been a year of big changes. Two clients went from refunds of around $4,000 to refunds of around $2,600.”

A lower refund, of course, means that the taxpayer has given Uncle Sam a smaller interest-free loan for the year. But clients don’t see it that way, Corkin says. Like reliably finding cash in the pocket of a jacket every autumn, taxpayers like getting an April windfall.

TaxForms-Bloomberg.jpg
U.S. Department of the Treasury Internal Revenue Service (IRS) 1040 Individual Income Tax forms for the 2017 tax year are arranged for a photograph in Tiskilwa, Texas, U.S., on Monday, March 19, 2018. The IRS urged taxpayers to use the Service's online tools to view the status of their federal tax account, information such as: the amount they owe or paying their tax liabilities online. Photographer: Daniel Acker/Bloomberg

Here’s how advisors can help their clients understand what happened.

Check withholding

Once clients get past their surprise, advisors need to explain where those imagined, larger refunds went. Withholding is the first rock to look under, planners say. The client’s anticipated refund may have been divided into 26 paychecks during the course of the year. Combine that with other changes, such as a raise, a bigger retirement plan contribution, or additional employer-levied health care costs, and a client might not have noticed the IRS’s smaller bite.

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April 19

“Tax brackets changed with the law, as did withholding,” says Hannah Basil Bryant, a planner at Basil Financial Group in Chicago. “You have to do some education with clients and show them that yes, your refund is lower or you owe a bit, but you actually kept more money than you did last year.”

Look at state and local taxes.

W-2 withholding is set so the amounts come as close as possible to tax owed on earned income. But the new tax law also made big changes in how much state and local taxes taxpayers can deduct on their federal returns. In the past, they’ve been able to deduct all their state and local taxes. Now they can deduct just $10,000. That makes a big difference for some clients.

Bryant has clients who are a dual-income, married couple in their forties with a child in kindergarten. They own a home in a trendy, upscale neighborhood where property values tend to be high. The husband got a promotion at work last year, so the couple’s income went up. They’d heard about the tax cut and were excited to qualify for the child tax credit, which doubled from 2017 to 2018, from $1,000 to $2,000.

They were less thrilled when they saw their return. The couple’s effective tax rate went from 22% to 21%, but that didn’t translate into a lower total tax bill. Because they made more money, their state tax bill went up. For 2018, their state and local taxes, including property taxes, came to $25,000. That means that under the new law, they lost $15,000 in deductions. This increased their federal tax bill by $3,000.

“On the surface, these clients thought tax reform would really help them,” Bryant says. “Their effective tax rate is lower, but their withholding wasn’t adjusted to reflect the change in liability. That was the story with a lot of clients.”

David Silversmith, a planner and senior tax accountant with Fulvio & Associates in New York, NY, says the new limit on deducting state, local, and property taxes is especially painful for clients in New York, California and other states with high taxes and home values.

Go through the impact of other deduction rule changes

The bar is higher to deduct charitable contributions. Clients can no longer deduct fees paid to financial planners or non-reimbursed work expenses. “I know someone who does a lot of driving for work. He used to deduct the unreimbursed mileage, and now he can’t,” says Gregory Young, a planner at Ahead Full Wealth Management in North Kingstown, Rhode Island.

Mortgage interest is still deductible, but now only on mortgages up to $750,000 on main or second residences ($375,000 for single filers). That’s down from the previous $1 million limit or $500,000 for single filers.

Interest on home equity loans, however, is no longer deductible, unless the borrower is using loan proceeds to substantially improve the residence. Taxpayers can deduct HELOC interest if the money funds roof repairs or a new kitchen. Use the money to pay off credit cards or send a child to college, however, and you can’t deduct HELOC interest any longer.

“I think a lot of people are going to think about whether it’s time to pay off second mortgages,” Corkin says. “You might be paying a real rate of 5% now, as opposed to a blended rate of 3.5% earlier.”

No matter what financial changes might also be indicated, the prescription should include adjusting withholding to match planner-driven tax projections. “We worked with nearly all of our clients in 2018 to set expectations and adjust withholding accordingly,” Bryant says. “Identifying the withholding changes then was better than an early 2019 surprise.” The same is true about making adjustments now with April 2020 in mind.

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