As advisors, we want to meet financial goals and get the best returns for our clients at the least amount of expense. Doing so requires strategic and thoughtful planning, especially this time of year when the tax collector comes calling. Likewise, we’ve assembled some tips for financial advisors this tax season to keep their clients in the know.
The Type of Account Makes All the Difference
The type of account used to position clients’ assets has implications on the amount of taxes they will have to pay every year. Accounts are either taxable (regular brokerage accounts), tax deferred (traditional IRA or 401k plans) or tax free (Roth plans). The idea is to place assets that kick off ordinary income tax in tax-deferred or tax-free retirement accounts to avoid paying the higher tax on a yearly basis. For taxable accounts, investing in assets that kick off capital gains, primarily long-term capital gains, would be beneficial since long-term capital gains are taxed at lower rates than ordinary income. Therefore, using municipal bonds, tax-efficient ETFs and mutual funds, and dividend stocks that utilize qualified dividends all make sense to use in taxable accounts.
For reference, dividends paid on stocks are classified by the IRS as either ordinary or qualified, and are taxed at different rates. While ordinary dividends must be reported as income, qualified dividends can reported as a capital gain. In order for a dividend to be considered qualified, the stock must be held by the client for more than 60 days in the 121-day period that began 60 days before the ex-dividend date.
Bonds and less efficient mutual funds are better suited for tax-deferred or tax-free retirement accounts.
Take the hit now? Or later?
Many clients will question whether tax-deferred or tax-free accounts are best for their personal situation. Anyone who is younger in age (with more than 15 years to work until retirement age) and can forego the immediate tax benefit should elect to use a Roth account for retirement savings. Traditional tax-deferred accounts will require clients born after the year 1960 to begin taking distributions of the money they saved by age 75, when they’ll be dealing with a larger bucket of money and likely a larger rate of tax. It’s worth it for the client to pay a little tax now and avoid the required minimum distributions down the road. And when they do take the income out of their Roth account down the road, it won’t affect their Medicare premiums.
You’d have to be fortune teller to guarantee without a doubt that the tax rates will be higher for a client when they reach retirement age, but it doesn’t require a sixth sense to observe the past and current trends in government spending and make an educated guess.
Don’t Rush to File
A lot of clients who are expecting tax refunds love to file as soon as they receive their 1099 form. But if their investments involve mutual fund companies that receive income from interest, dividends, qualified dividends and capital gains distributions, there are sometimes corrected 1099 forms sent out after the initial forms are received.
Mutual fund companies receive the information they provide on 1099s from various investments like qualified dividends, and then aggregate the data to provide to brokers. However, if any of these income sources are incorrect, then there is a change in reporting and a corrected 1099 must be issued. If the changes make a material difference to the client’s financial situation, then the IRS will require the client to file an amended return.
While most corrections are minor and have little effect on the return, it’s usually the better option to wait for any corrected forms to arrive before filing in order to avoid the pain and potential expense of filing an amended return.
For more information on current regulations and how to keep your clients on track for financial success, please contact us.
