Advisor Helps Client Slash Taxes on Inherited Assets
From: rethinking65.com
After spotting red flags on a prior-year tax return, the advisor, an enrolled agent, dug deeper to find more tax-efficient solutions.
Like most financial advisors, Seth Thompson of Forward Financial Planning LLC prefers not to prepare tax returns for his clients. But by providing complimentary reviews of tax returns to onboarding and existing clients, he has uncovered tax issues missed by their outside CPAs.
“I don’t like to call out a CPA, that’s just not the intent,” he says. “But CPAs, they’re not going to ask for – I shouldn’t say that, tax preparers only — aren’t going to ask for more information than they need.”
Thompson, based in the Denver-Boulder metro area, is an enrolled agent, a credential that enables him to represent clients before the IRS. Yet “even advisors who don’t specialize in taxes, I think they’re starting to ask for the tax return because it’s a much easier reference and it kind of helps get everyone on the same page as far as terminology,” he says.
For example, when speaking with a new client about their retirement accounts, “they may not know if it’s a qualified plan, nonqualified plan – it gets complicated very quickly,” he says. “So, if you have the tax returns and know how to read them, you’re going to get 85, 90% of the starting information that is a solid foundation.”
Playing Detective
Doing complimentary tax returns has so far landed Thompson two wealth management clients. He also does some one-off tax work. Two tax reviews in particular stand out for Thompson. One involved a prospect, now a wealth management client, who had inherited assets from her parents. The other review was for a small business owner, Thompson’s specialty, who was already a client.
“Something wasn’t sitting right when I was digging through the [past-year] returns and I was able to uncover opportunities for both clients to not only correct tax returns, but also enhance their relationships with their tax preparer by including them in the ongoing planning process,” he says.
The heir had expressed unhappiness with the CPA she had hired to do her taxes because she felt the CPA hadn’t provided sufficient advice for future years. Thompson helped her understand that this was beyond the scope of their engagement.
“Tax preparation is a backward-looking service. Anything advisory side is forward looking, so it’s not like your CPA is bad,” he explained. “They’re doing their job, and they’re not going to ask for more than they need, because they can get a lot of liability added to the plate.”
Thompson emphasizes that neither of the clients’ tax situations was a quick fix after he identified the issues on their tax returns.
“Each of these scenarios involved many professionals across firms working together to facilitate complicated asset transfers and account for them properly on tax returns going forward while incorporating them into a plan that will save thousands in taxes over the next five years for these clients,” he says.
Inherited-Asset Overhaul
In the first example, Thompson noticed the taxpayer had received a taxable portion of a distribution from a retirement account that didn’t look quite right. Although it involved inherited assets, the tax returns lacked documentation accounting for cost basis.
“Several red flags were essentially popping up in my head,” he says, “and I had to dive quite a bit deeper into this overall project,” which involved the transfer of nonqualified plan assets. The heir had inherited two annuities and an IRA. .
She lost her remaining parent, which triggered an inheritance. Her parent’s death was about three weeks before a SECURE Act rule was implemented that requires most non-spousal beneficiaries of retirement plans, including IRAs,401(k) and annuities held in retirement accounts, to withdraw all their inheritance in 10 years. Yet the SECURE Act’s 10-year rule does not apply to nonqualified annuities, which are held outside a retirement plan and purchased with post-tax dollars.
Thompson requested more information from the client and with her permission connected with the client’s CPA. The CPA was unaware that this particular inherited asset was subject to more favorable tax treatment than the client had received. In the CPA’s defense, the annuity product type was very rare and the client thought she had given the CPA all the information but hadn’t, “which is understandable,” says Thompson.
Additional Concerns
So, once they realized these were nonqualified annuities, “at first glance, it seemed favorable — if you can, you want to stretch out your distribution options and not take it in a five- to 10-year period,” says Thompson. “But this was a very peculiar case: Why did this client have two different inherited annuities? Why hadn’t they been consolidated if they had the same underlying investments?”
As Thompson dug deeper into the investments that he learned about through the tax return, he also discovered “the client was not getting the most favorable fee structure [on the annuities] and they weren’t getting the services that they thought they were paying for from their quote, unquote advisor [on the annuity contracts],” he says.” He had a hunch there was more he and the client’s CPA could do to help the client’s tax picture.
Upon examining the situation, “we actually had to consult legal services as well just to make sure our interpretation was correct. It was correct, and we were able to consolidate the three different inherited accounts into a more tax efficient vehicle,” says Thompson. “We were able to essentially take those two annuities and roll the money from the annuities into the inherited IRA and maintain the stretch provisions allowed under the annuities.”
Slashing Fees, Preserving Cost Basis
By rolling the annuities into the inherited IRA, “we were able to save 2, 2 ½% in advisory fees alone, just by getting it outside of the wrapper of the annuity,” says Thompson.
The annuities were very risk averse, in line with his client’s risk profile. “Yet, this was essentially just like a CD sort-of annuity, which means, why are you paying 2% for someone to manage your CDs? That was rubbing me the wrong way,” he says. “You don’t need to have a high fee structure to do a one-and-done sort of product.”
In addition, “we were able to preserve the cost basis,” says Thompson. To explain this more easily, he shared some hypothetical numbers. “Let’s say the parents paid $10,000 for an annuity and then went back a few weeks later and bought another $10,000 annuity,” he says, resulting in a total cost basis of $20,000.
If the $20,000 grows to $50,000 over the years and “we transfer $50,000 of an annuity to an IRA or any other vehicle, the IRS is just going to see a $50,000 transfer,” he says. “So, what they’re going to think, unless you document this, is that you have a $50,000 potential taxable gain” instead of $30,000.
“I made sure I detailed the new cost basis and even included a description on the return for the IRS to see what I was doing,” says Thompson. He saved the client, who was in a high tax bracket, about $15,000 in taxes.
Deferred Taxes and Lower Medicare Premiums
Transitioning from an annuity into an IRA also means the client will be able to defer those taxes on these withdrawals over that stretch period, “which is the rest of their life,” says Thompson. The IRS’s lifetime-expectation table can be used to calculate one’s tax bill based that beneficiary’s age, he notes.
Another critical piece for this client is that she was nearing that two-year lookback window for Medicare open enrollment. The IRS uses two-year-old old tax returns to calculate premiums. “We were able to escape a high tax bill and prevent her from being subject to income-related IRMAA premiums,” says Thompson.
‘The Tricky Part’
When it comes to inherited assets, each client’s situations should be reviewed on a “case-by-case basis,” says Thompson.
You can combine accounts with the same tax profile, “meaning you can go from a 401(k) to a 401(k) or you can go from a 401(k) to an IRA,” he says. “You can technically go from an annuity to an IRA but the tricky part is when it has that inheritance label on it. That’s where you have to be careful and have coordination awareness.”
The client couldn’t just roll the annuities into her own IRA and preserve the tax benefit of the inherited assets, he says, noting that this would be considered a liquidation and could exceed IRA contribution limits, he says. “They were able to roll it over because it was an inherited IRA.”
“What we had to do was get a letter from the custodian, explaining, ‘Hey, this is what’s going on,’” Thompson says. “That took me three months, because every time I would speak with somebody, I would say, ‘I’m trying to facilitate the transfer. Here’s the IRS code that says it’s legal.’ It just needs to be accepted by both parties.”
The Benefits of a Bookkeeper
In the second client example, the small business owner told Thompson shortly after filing his taxes that his business had been expecting a tax refund, not a tax bill. While reviewing the tax returns, Thompson realized the client should have provided his CPA with more information from his business’s books.
The business owner, a partner in a professional practice, told Thompson that an internal administrative employee had been doing the business’s tax work. It turned out the administrator “wasn’t classifying contractor payments and they weren’t including that in their tax deduction,” says Thompson.
He has seen many small business owners fail to hire a bookkeeper because they’re trying to keep costs lean, but “it’s super inefficient,” he says. His recommendation: Hire a bookkeeper to tune up the books before sending them to the CPA. “You don’t have to have an in-house bookkeeper or a KPMG big consultant — just have a service do this for you once a year,” he says. “The cost varies but in my opinion the cost is well worth what you’re getting and you can usually recoup some of the fees through the tax efficiencies that you gain.”
“Bookkeepers don’t have to have a CPA, but I would look for that credential if I was hiring a bookkeeper,” he adds.
The Big Allure
Doing tax-related detective worth without getting directly paid for this time won’t appeal to all advisors. But for Thompson, it’s “worth it in the end.” he says. When he talks to client about their user experience, they often tell him, “I’m not stressed about this, even though I don’t understand it and I don’t want to. I see the collaboration and hard work being done on my behalf and my team of service professionals is working for me (across service professionals),” he says. “Very cool to see.”
“Ten years ago, I would not have thought I would have loved taxes,” says Thompson, who has been an enrolled agent for three years and doing taxes for longer. “I’ve just been very interested in taxes because I see so many mistakes and I see that so many people in that CFP realm are afraid of taxes,” says Thompson. “That’s how I can differentiate myself.”
