Why Does my Financial Advisor Ask for My Income Tax Returns?

By: Nick Gertsema, AIF®, RICP®, Vice President & Wealth Advisor

When we are preparing and updating financial plans for clients and prospects, we like to look at prior years’ tax returns. Ideally, we like to see returns for the last few years. There are very important pieces of information in your tax returns that can help give us some insight so we can provide better advice.

We are not tax preparers, nor do we want to be, so why would a financial advisor review income tax returns? There are a few questions we are trying to answer, and some important pieces of information that are foundational to a financial plan tailor-made for you. Let’s look at those.

How Much Do You Need to Replace your Current Income?

First, we look for are the sources of income and amount that you are used to taking home. When we start a financial plan, we want to be able to make sure that we are driving at the right number.

When you retire, you’re probably not planning on taking a pay cut. On the flip side, you are also probably not spending as much as you are making. In retirement, you will probably no longer be contributing to a retirement plan or into Social Security and Medicare.

You may also have other sources of income other than the wages you get from your primary job. Your tax returns are a great place to find some of that income that may not be top of mind. Once we determine how much you are accustomed to living on, we can have a general idea of how much income needs to be replaced in retirement.

Creating a retirement income plan will combine Social Security, distributions from your investments, and any other sources of income to help you to maintain your current lifestyle.

Are There Opportunities for Tax Planning?

The Tax Cuts and Jobs Act was passed on December 22, 2017. There were some sweeping changes to tax laws that are not permanent. These tax law changes are set to expire after December 31, 2025. This presents a unique opportunity for long-term tax planning.

Not only were tax rates reduced, but the standard deduction was also increased. For example, in 2017 the standard deduction for married filing jointly was $12,700. In 2018, the standard deduction went up to $24,000 for married filing jointly. Whereas you may no longer be able to itemize, your deduction could possibly have gone up drastically.

Not Getting a Refund doesn’t Mean You Paid More in Taxes

When I review tax returns, I like to compare the most recent returns to 2017 to see how much you are paying in taxes and how much it has changed. Some people will say that the tax law changes hurt them because they can’t itemize anymore and didn’t get a refund.

Not getting a refund doesn’t mean that you paid more in taxes. Owing taxes and getting a refund are a product of whether enough or too much taxes were withheld from your income. The best gauge of how much you actually paid in taxes is on your tax returns.

Which Marginal Tax Bracket are You in and What is Your Effective Tax Rate?

When tax planning, the difference between your marginal tax rate and effective tax rate is a big deal.

Just because you are in the 22% marginal tax bracket does not mean that you are paying 22% of your income in taxes. The federal tax brackets are progressive. That means that you pay 22% on only the money that falls in that income range. For the income that is in a lower marginal tax bracket, you pay that lower percentage.

A closer estimate of how much you are paying in taxes is your effective tax rate. The effective tax rate is calculated by taking your total taxes paid by taxable income. This amount will be lower than your marginal tax rate. For example, your income could put you in the 22% tax bracket, but your effective tax rate could be closer to 15%.

Do You have any Tax Losses Carried Forward?

An investment sold for a loss in previous years can have tax benefits. If you had an investment that was sold for a long-term loss and was not offset with long-term capital gains in the same year, you can carry forward that balance.

You can use up to $3,000 per year to offset any long-term capital gains until the balance is used up. Knowing that there is an unused tax loss could create an opportunity to sell some positions that have capital gains without causing too much of a taxable impact.

What Does This Mean to You?

Understanding your entire financial picture enables us to give better advice. Your tax returns are great historical documents that help us understand where you’ve been, so we can be helpful in getting you to where you want to go.

We’ve been able to help clients make some of life’s decisions on their terms by showing them the opportunities they have before them.

In 2019, the markets were up. For our clients who were no longer able to itemize their mortgage interest, it made sense to take some additional withdrawals from their IRAs to pay off their mortgage to help with their long-term cash flow.

At the beginning of 2020, we witnessed a historical drop in the markets. This opened the window for some clients to make Roth conversions. We were able to convert some of their traditional IRA assets into Roth IRAs. This way we could have an option for tax-free withdrawals later in retirement when the income tax treatment may not be preferential.

We are always here to help. We have the technology to try different scenarios and see how some small tweaks now could impact your overall financial plan. If you’d like for us to illustrate how some of these strategies may benefit you, make an appointment today to start the conversation.

Set Up an Appointment!

For a comprehensive review of your personal situation, always consult with a tax or legal advisor.

Get in Touch

In just minutes we can get to know your situation, then connect you with an advisor committed to helping you pursue true wealth.

Contact Us

Stay Connected

Business professional using his tablet to check his financial numbers

401(k) Calculator

Determine how your retirement account compares to what you may need in retirement.

Get Started