Look no further: Tax-reduction opportunities start with the return

A mid-year review can reveal countless opportunities for all types of taxpayers and their advisors to plan ahead for next year

By: Gil Charney  /  June 13, 2016

Even after tax season has been over for several weeks, taxpayers who have smugly filed their tax returns away for another year should think again. Taxpayers can benefit dramatically from spending an hour or two reviewing their tax returns now.

Why? Because a thorough review can reveal opportunities to maintain or reduce tax liabilities for next year.

Review the return midway through the year

Mid-year is a great time to review a tax return for savings opportunities, for at least two reasons:

  • Information on the prior year’s tax return is still fairly fresh in mind.
  • There’s enough time to make changes in the current year without drastic, last-minute actions.

Waiting until December to identify planning opportunities may be too late, or force taxpayers into making bad decisions to save a few dollars. If taxpayers don’t feel comfortable performing this review on their own, reaching out to a tax advisor for a review and guidance is a smart move for effective tax planning ideas.

Not all tax-return reviews necessarily result in opportunities to lower tax bills. But the review may expose financial planning opportunities such as revamping a portfolio to improve investment earnings or refinancing a mortgage.

Unless the tax advisor is also a financial or investment advisor, he or she should not be making specific investment or financial planning recommendations. However, determining the tax impact from such financial decisions is clearly within the tax advisor’s realm, and a client whose investment advisor can work with his tax advisor has balanced support.

Tax-reduction essentials

Generally, the more complex a taxpayer’s return, the more planning opportunities there may be. However, any taxpayer can benefit from a little planning, and the first place to start is the most recent tax return. Here are a few essential concepts to keep in mind when it comes to identifying tax-planning strategies on a return.

Even seemingly small changes can make a big difference

Opportunities vary from taxpayer to taxpayer, but given the complexity of our tax laws and the many forms and line items that make up a tax return, taxpayers need not make sweeping changes to their financial or personal lives to reduce their tax liabilities.

For example, if a taxpayer reduces his or her adjusted gross income even a smidgen, such as by contributing to a traditional IRA or using a net capital loss to reduce ordinary income, the taxpayer may qualify for several tax benefits.

Tax returns can tell us a lot

Many taxpayers mistakenly think that tax returns simply reflect financial events and transactions, such as salaries, investment income, capital gains, rental income, etc. In reality, the reach of tax law into our non-financial lives is much more extensive.

Life events such as marriage, divorce, having children, retiring, etc., all have tax consequences. Few taxpayers experience these life events solely for tax reasons, but unfortunately, many taxpayers ignore the tax impacts until they file their returns.

Tax planning is about more than payment strategies

Two common tax-related analyses are planning the right tax withholding amount from wages, and determining the minimum estimated tax payment to avoid a penalty or keep a refund or balance due as close to zero as possible.

While these analyses are important, they don’t impact the actual tax liability. Tax planning goes further, to reduce the tax liability, not just how the liability is paid through withholding and payments.

Two examples scratch the surface of what’s possible

Below are just two of countless examples of how taxpayers and their advisors can use tax returns as a diagnostic tool to reduce future tax liabilities.

Example 1: Laura plans for Head of Household filing status

As noted above, many aspects of a taxpayer’s non-financial life affect the tax return. Every taxpayer must indicate a filing status. The rules for choosing the correct filing status can get complex in many situations.

If a taxpayer qualifies to use more than one filing status, he or she should choose the one that minimizes tax liability. While taxpayers don’t often have the option to choose a filing status, knowing the rules may allow some taxpayers to “plan” their filing status.

For example, Laura is a married taxpayer who recently separated from her spouse and doesn’t want to file a joint return with her spouse. Although she is still legally married, she may be treated as “unmarried” for tax purposes and so qualify for Head of Household (HH) filing status if she:

  • Has a qualifying dependent
  • Pays for more than half the cost of keeping up a separate home for herself and the dependent during the year
  • Has lived apart from her spouse for the last six months of the year

The benefit of HH filing status is tax reduction, versus the least desirable Married Filing Separately (MFS) status. A taxpayer with $50,000 in taxable income who files HH falls in the 15 percent tax bracket, versus the 25 percent tax bracket for MFS.

To successfully claim HH status, Laura must:

  • Understand what expenses qualify for keeping up the home
  • Keep meticulous records of expenditures to support this requirement
  • Ensure that Laura’s home is the main home of the couple’s child for the year
  • Not live with her spouse

Planning is essential here. If Laura’s child spends more time at the house of her spouse or another relative than with her, or if Laura spends one night in her spouse’s residence during the last 6 months of the year, she may be disqualified from using the HH filing status. Several other tax benefits could also be at stake: medical expenses paid for the dependent (if the dependent exemption is disallowed), the dependent care credit, etc.

For Laura, reviewing the tax return in May or June will mean that she has more than 6 months to comply with the requirements for HH. This is also a good time for Laura to understand the tax implications of divorce. If she or her advisor analyzes the return in July or August, she can’t roll the calendar back to comply with the “more than half the year” requirements for using the HH filing status.

Example 2: Phil has a high salary, but needs to review investments and spending for possible tax savings

Phil, a 50-year old married taxpayer with a salary of $260,000, interest income of $5,000, and little other income may immediately raise questions from his tax advisor about income from investments, rental property, business income, and other sources.

Phil and his wife, Ann, explain that they have large CDs, savings, and other assets that generate little income. Phil also mentions that he is paying off student loans for his older child and other personal loans (for his boat and luxury cars), interest for which doesn’t appear on the tax return. Phil and Ann have a large mortgage with interest reported as an itemized deduction, along with high real estate and personal property taxes.

Phil and Ann also have a child who started college last year, but didn’t qualify for financial aid. Phil’s income excludes them from any education tax benefits.

Phil’s tax liability is more than $45,000, including roughly $3,900 in alternative minimum tax (AMT), $715 in additional Medicare tax, and $175 in net investment income tax. Phil and Ann may not be able to itemize deductions in tax years 2018 through 2025 due to the increased standard deduction and the $10,000 cap on state and local taxes, such as real estate and personal property taxes. Additionally, Phil and Ann are subject to less AMT for tax years 2018 through 2025 due to the increased AMT exemption amount and phaseouts.

Phil and Ann meet with their tax advisor and investment advisor to customize a financial and tax plan. Their tax advisor discusses the benefits of Phil contributing to (or maxing out, if possible) his 401(k) at work. Deferring tax on Phil’s salary by $24,500 would reduce his tax liability (and AMT). However, Phil and Ann have loan payments to make, so contributing that much to the 401(k) might be unrealistic.

As for the student loans, Phil and Ann might consider gifting money to their oldest child, who might benefit from deducting the student loan interest if he is no longer a dependent and the loans are in his name. Using gift-splitting, they can gift up to $30,000 per year to their son without gift-tax implications.

Their financial planner and investment advisor help Phil and Ann look for ways to reduce spending and make 401(k) contributions less painful. For their large expenditures, their tax advisor will analyze whether they will be better off claiming the sales tax deduction (which is deductible for AMT purposes), rather than claiming the state income tax deduction.

As for Phil’s lack of significant investment income on their tax return, perhaps he has a considerable portfolio of stocks, mutual funds, or exchange-traded funds that do not pay dividends. He may have overvalued investments that he should sell, triggering capital gains, which, at a 20 percent tax rate (23.8 percent, including the net investment income tax), is not a bad ticket to punch for profit-taking.

Phil and Ann’s investment advisor can help determine the impact of such sales on their portfolio, while their tax advisor can assist by determining the potential tax impact of these sales. The tax return is an excellent diagnostic tool for exposing these opportunities.

There are many more possibilities

This article presents only two examples that illustrate how a tax return can be a planning tool. Tax returns can reveal a broad range of additional and varied opportunities for different types of taxpayers. For instance:

  • Business owners can review their last return and periodically review their property usage throughout the year to help ensure they qualify for a Section 179 deduction.
  • Individual investors can review their last return and income projections to help determine whether they qualify to make a deductible IRA contribution, and, if not, make other plans.
  • A self-employed individual may consider hiring his or her spouse to reap the associated tax benefits.
  • And many more.

In the end, the place to start is the tax return. If the review happens relatively soon after taxpayers file their returns, taxpayers will have more time during the year to make decisions and implement changes that impact the current year’s tax liability.

Editor’s note: This article has been reviewed for changes following the passage of the 2017 Tax Cuts and Jobs Act. The information provided in this article modified based on the TCJA. Specific dollar amounts were also updated to 2018 inflation adjusted amounts.

Author Name

Gil Charney

Gil Charney, CPA/PFS, CFP, CGMA, CMA, MBA, is a former director of tax law and policy analysis at The Tax Institute. Gil oversees a team of tax attorneys and CPAs who review and analyze legislation and the impact of tax laws on taxpayers. He has more than 30 years of experience in tax, accounting, and financial management.

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