For most people, a tax return is the most consistent, if not the only, measure of their financial life. Investment statements can be glossed over, credit scores can be ignored, but like clockwork, the IRS comes back every year asking all of us to take inventory. This can create a massive opportunity for financial advisors, if they know where to look. Whether serving existing clients or courting prospects, the tax return gives an advisor a consistent tool to understand where a person is financially and what opportunities might be available to them.
This “opportunity” is not about increasing client count. It’s about delivering massive value to individuals. Success for financial advisors should be measured in the impact they are able to have on an individual’s financial life. Specific to taxes, this means understanding where a taxpayer is currently and then providing the education and action plan to take advantage of the choices the tax code provides. Education and action are both critical steps in that process.
[SUBSCRIBE: Get the weekly U.S. News newsletter for financial advisors. ]
The Number Taxpayers Care About
Most taxpayers can tell you, without looking at their tax return, whether they made a payment or got a refund at tax time. They likely can even tell you approximately how much the refund or payment was. This is also typically the number on the tax return that has the strongest emotional response for taxpayers, and unfortunately it is a terrible measure of how effectively a person is handling their taxes.
Watch any commercial for a big tax preparation firm and it is easy to see why everyone gets so locked in on this number. The industry has been training taxpayers to have a laser focus on getting the largest refund possible. The problem is that a large refund simply means that you overpaid the IRS and has nothing to do with whether any tax planning took place. Being proud of a large refund is no different than walking into a store and giving the cashier $1,000 to pay for $100 in groceries. That doesn’t make you an expert shopper.
Successful tax planning is about the amount of a taxpayer’s hard-earned money the IRS kept each year.
The Number That Matters
If a refund or payment is the wrong number to focus on, taxpayers need to be educated on what they should focus on. Depending on the individual situation, there are plenty of numbers that should be considered, but for every taxpayer, Line 24 of IRS Form 1040 needs to be understood. Labeled as “Total Tax,” this line represents the amount of a person’s hard-earned money the IRS is going to keep for the year.
This number is crucial for taxpayers to understand before any other planning is done so there is context for why the planning matters. Fixating on a $5,000 refund can distract from $50,000 in taxes the IRS kept. Everyone can get a $5,000 refund — it’s as simple as sending the IRS an extra $5,000 in estimated payments. Only taxpayers who plan ahead, or work with a financial advisor who can help them plan ahead, will actually lower the amount the IRS keeps.
Think Long Term
The second piece of education that every taxpayer needs is that tax planning is a long-term play. Waiting until February 2023 to think about taxes for 2022 means most of the potential opportunities have already passed. Great financial advisors are working with their clients in 2022 to make a plan for taxes over the next five, 10 or even 20-plus years.
This is not an exercise in trying to make a crystal ball work. Any future planning is going to be an estimate. However, understanding how much a client will pay in taxes if no action is taken provides a baseline for asking questions on what might be possible. What if they switched to after-tax contributions from pre-tax contributions? What if they used a donor-advised fund instead of gifting directly to charity each year? What if instead of selling an asset all on one day, the sale was split between Dec. 31 and Jan. 1?
Sanding Off the Edges of a Lifetime Tax Bill
With any planning, it is important to set clear expectations. The goal of tax planning is rarely to reduce taxes to zero. This might be possible in a single year, but over a lifetime, taxes will need to be paid. Winning at tax planning is about incremental change. It is about sanding off the rough edges of the tax bill someone pays over the lifetime of their wealth.
Saving $1 million in taxes in a year might get the headlines, but that is the rare exception. More often, great tax planning is saving a few thousand dollars here and there, so that over a lifetime, the savings can add up to tens and hundreds of thousands of dollars. For this to be a reality, financial advisors have to take consistent, intentional action. The advisors who are the most successful with tax planning have a system for getting client tax returns each year, reviewing and analyzing those returns, and then providing education and recommendations to their clients.
More from U.S. News
What Is an Irrevocable Life Insurance Trust and Do You Need One?
How to Choose the Best Financial Planning Software
The Top 3 Wildcards Advisors Must Consider in 2022
How to Use a Client’s Tax Return to Map Financial Success originally appeared on usnews.com
