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Tax Planning Missteps That Cost Clients Money

December 18, 2014

Tax management is more important for the advisor-client relationship now than it has been for six years. Strong market performance is resulting in some of the largest capital-gains distributions investors have seen from mutual funds and ETFs since the financial crisis.

Indeed, Morningstar estimates the typical mutual fund will distribute gains in excess of 10% of net asset value for 2014, an increase from the 5% rate investors saw over the past five years. That would expose a client with a $100,000 investment to $10,000 in taxable distributions. The tax bill’s exact size will depend on the investor’s federal income tax bracket and how long he or she has been in the fund.

Meanwhile, ETFs’ growing popularity has made investors more aware of factors like tax efficiency and fees — which have nothing to do with investment performance — and their impact on returns. In this environment, advisors who offer clients forward-looking and customized tax-management strategies can really add value.

Potential tax mistakes can chip away at investment returns. As advisors complete their year-end tax planning, they should make sure to avoid these three missteps:

Failure to check holding periods of securities before selling. When advisors sell appreciated stock that a client has owned for less than a year, the client owes tax at the ordinary income tax rate rather than the capital-gains rate (15% for 2014). Depending on the client’s bracket, the difference can add 10 percentage points or more to the rate he or she will pay.

Weak collaboration with tax preparer. Advisors who lack a good working relationship with a client’s tax preparer could wind up making expensive errors. Take Form 1099-R, the IRS filing that covers retirement-account distributions. Various sections of the form tell the preparer how to enter various amounts as taxable, not taxable or subject to penalty. However, Form 1099-R is not very clear about which IRA rollover transactions are exempt from the 10% early distribution penalty. Advisors and preparers should work together to ensure clients aren’t exposed to unnecessary taxes or penalties.

Mishandling required minimum distributions. Advisors must guide clients on whether to take the first required minimum distribution (RMD) from IRAs as soon as they turn 70½ or to postpone it until April 1 of the following year. The wrong decision may have significant consequences, as postponing the first RMD may cause the client to receive two RMDs in the next year — pushing him or her into a higher tax bracket. As for clients who are already taking their RMDs, don’t forget to keep them informed of changes to the tax code.

Ultimately, financial advice and tax planning go hand in hand, as both directly affect the client’s ability to achieve stated goals. Overall, while Roth and traditional IRAs have strong tax advantages, they can cause problems if a client overcontributes, for example. That’s why staying aware of the tax laws — and communicating changes to clients — will always make one a better advisor.