Financial advisors have lots of experience acting like detectives as they try to learn about their clients and deduce the best course of action for their investments. But on the cusp of tax day, advisors should take their Sherlock Holmes skills one step further and engage in a bit of forensics, studying tax forms to find evidence that can help them help their clients.
The technical definition of forensics relates to searching for evidence of a crime, which we hope is not what you encounter. Instead, I want you to consider reading certain tax forms with an eye toward learning more about your client and how you can serve them even better.
Ground rules for client tax form forensics
First, I want to make clear that as a financial advisor, you need not be a tax expert in all things. However, you should be tax-smart when it comes to investment recommendations. Our goal here is not to offer tax advice, but to point you toward relevant information about your client.
It's also important to remember that sharing tax documents is an act of trust. You need to have the kind of relationship where clients and prospects are willing to share personal information, and you need to make clear the value exchange: You are doing this to help identify opportunities for better, more personalized investment choices.
Finally, you shouldn't expect to find a single obvious issue with an easy solution. Most often, this is really like detective work — you see evidence that there is something possibly amiss and you need to do a deeper dive to learn more. This might mean extra work but it's through that legwork that you can create value and earn the trust and business of your clients.
What forms are we looking at?
There are over 800 tax forms, but the good news is advisors need to be familiar with only a few. The forms that may yield the most insight into a client's investment tax situation are:
· Consolidated 1099
· Form 1040
· Schedule B — Interest and Dividends
· Schedule D — Capital Gains and Losses, Capital Loss Carryforwards
· Schedule D's supporting document — Schedule 8949, which documents all buys and sells for the year
Keep in mind that reviewing these forms may also reveal assets held away that are not part of a comprehensive financial plan. Accounting for 100% of your client's assets will improve the financial plan.
Here are 4 key tax form forensic opportunities for a financial advisor.
1. Form 1040
a. Line 2a, Tax-Exempt Interest: Does tax-free bond interest make sense based on the client's tax rate? Or should more municipal bond exposure be considered? (This can also be found on the 1099-DIV in Box 11.)
b. Line 2b, Taxable Interest: Does the amount of interest income indicate the client is potentially holding too much cash? Is the interest income high relative to the client's net worth?
c. Lines 3a and 3b, Qualified and Ordinary Dividends: Qualified Dividends are generally taxed at a lower tax rate. Subtract Qualified Dividends from Ordinary Dividends to see the amount taxed as taxable income at a potentially higher tax rate.
d. Both Lines 2 and 3, Interest and Dividends: Is the interest/dividend income being reinvested or used for living expenses? If being reinvested, the portfolio may be creating unnecessary tax drag due to an income preference. Other investment approaches may balance out the sources of return or reduce tax drag.
e. Line 7, Capital Gain or (Loss): See Schedule D to understand what is generating these amounts.
f. Line 15: Shows the amount of your client's Taxable Income used to calculate their tax rate. Knowing this allows you to zero in on the applicable tax rate to help them make better investment decisions. Without knowing the applicable tax rates, it's challenging to make informed decisions on taxable accounts.
g. Page 2: Tax Preparer Signature: Knowing who prepares your client's taxes, and forming a relationship with that person can help you coordinate and serve your client better — especially for your top clients.
2. Consolidated 1099
a. 1099-DIV, Boxes 1a and 1b: This is where you can see the detail supporting the numbers on the Form 1040, lines 3a and 3b. Do the totals match? If not, there may be assets held away that you are not managing or aware of in the financial plan. Also, qualified dividends are generally taxed at lower rates. If Box 1a is significant, and/or much higher than 1b, ask the client what they are doing with this ordinary income. Is it being used for living expenses that year, or is it being reinvested? If it's being reinvested, they may be paying unnecessary taxes.
b. 1099-DIV, Box 2a: Box 2a shows Capital Gain distributions from mutual funds. If there is a number here, you should check out the Consolidated 1099 to see what funds make up this number. Does the size of the distributions appear high versus the industry average? Does there seem to be a disproportionate amount of capital gains characterized as short term vs. long term? Remember that the tax rate can be materially higher for short-term capital gains. potentially lower their tax bill.
c. Line 13: Provides mutual fund distributions referenced on 1099-DIV, line 2a. See the detail in the Consolidated 1099 to understand sources and materiality.
3. Schedule D – Capital Gains and Losses:
a. Lines 2 and 9: Show the totals of short-term and long-term capital gains from selling capital assets. Do the amounts seem high relative to the size of the portfolio? Do short-term amounts appear high relative than long-term amounts? See the detail on Form 8949 to learn more.
b. Lines 6 and 14: Shows capital loss carryover — if any. If they have capital losses from prior years, this may be an asset that can be offset against future gains to potentially lower their tax bill.
c. Line 13: Provides mutual fund distributions referenced on 1099-DIV, line 2a. See the detail in the Consolidated 1099 to understand sources and materiality.
4. Schedule 8949 – Sales and Other Disposition of Capital Assets
This schedule documents all investment transactions for the year. See if there is unnecessary portfolio turnover. Do you see an investment objective in support of the amount of turnover shown? Part I lists the short-term transactions, while Part II shows the long term. If gains are being recognized, is there an investment reason the short-term sales could not have been delayed to long term to possibly get the lower tax rate?
Your goal is to serve your client's needs, and all the information collected here can help you ask better questions and perhaps make better recommendations. With a solid investment tax knowledge background and a little sleuthing, you can help yourself stand out as an advisor.
