Hidden in your 1040: Solid financial advice

Think of your return as an imaging device for your finances— a diagnostic tool that reveals where you can save more or spend less.

By Brad Burg
Senior Editor

Once that tax return is filed, probably the last thing you want to do is look at it again.

But that's exactly what you ought to do. After all, it's a financial imaging device. You'll probably pull the picture out next tax season, as a guide to the same chore—but why not benefit from the information now? A tax return can be full of money-saving hints and suggestions; you just have to know where to look.

"When starting out with new clients, I review their previous tax returns, and I often get good ideas that way," says Mary McGrath, a CPA and financial planner in Champaign, IL. In fact, she says, some points practically jump off the page. If a doctor is earning $130,000 and putting only $10,000 into a retirement plan, for example, she'll ask why the savings aren't greater. Or maybe a doctor's mutual fund holdings are generating capital gains that weigh in on Schedule D like a sumo wrestler. "That physician should consider a switch to more tax-efficient holdings," says John O'Connor Jr., a CPA in Albany, NY.

Many more lessons can hide in returns, lessons about everything from investing to practice management to retirement planning. Some examples:

Are you losing out by mishandling business expenses?

Where you deduct an expense can make a big difference. Have you been deducting certain practice expenses—travel or car costs, say—as personal, "unreimbursed employee expenses" on Schedule A? Better change tactics. You haven't been getting the full value of those writeoffs, because many personal deductions don't count until they hit a certain threshold. (In the case of miscellaneous deductions, that threshold is 2 percent of adjusted gross income.) Conversely, for high earners, some deductions phase out above certain limits.

Your practice, though, can deduct such costs fully. So if you're self-employed, have your practice write the checks this year, or at least reimburse you. "Sometimes doctor-clients—or their partners—are so worried about audits that they don't want the practice to pay those costs," says O'Connor. "But even if the figures are challenged, the amount involved can usually be negotiated."

Do you work for someone else? Try to get your employer to pay for expenses separately, and offer to accept that much less salary. This should make no difference to the employer; the dollars are deductible whether paid to you as salary or as an expense reimbursement. But for you, switching to the reimbursement approach will cut taxable income, notes CPA Gregory Goergen of Arlington Heights, IL. One note of caution: Lowering earnings can also reduce benefits tied to income, such as retirement-plan contributions. So consider that tradeoff.

Are you losing part of the value of deductible fees?

Other deductions taken on Schedule A can shrink, too, so see what else you can report on another part of the return next time around. For instance, what about those tax preparation fees? "When I inquire," says CPA Robert Baldassari, of McLean, VA, "I find that many doctors can allocate part of them elsewhere, sometimes to a rental property, farm, or small business. Have your advisers prepare their invoices to show this, when that's legitimately possible."

Also think about any legal fees you've paid personally. Is some of that work attributable to your practice or to an investment, such as a real estate holding? Even if you can't verify or document that for legal fees you've already paid, you can certainly leave a clear paper trail regarding future ones.

Are you ignoring possible interest deductions?

Take a look at your deductible mortgage interest and any other interest payments you're making. Do you have car loans? A boat loan? Any other personal borrowing? Consider converting those other loans into deductible home equity debt. "Sure, your GMAC auto rate may be 7 percent, and a home equity rate might be 9 or 10 percent," says McGrath, "but that higher-rate loan is deductible, so it may effectively be 30 to 40 percent lower, depending on your tax bracket." You might save substantially by switching to a home equity loan this year.

With a boat loan, you might not have to switch. "A boat with living accommodations often qualifies as a second home, making related loan interest deductible, just like mortgage interest," notes CPA Tom Ochsenschlager of Washington, DC. Other factors can come into play, though, he cautions—for example, whether you already have a second home.

Should you look more carefully at tax-free earnings?

Your return can alert you to consider taxes when choosing investments, too. Sure, before-tax returns may look glamorous, but so did the hare at the start of the race. Your return, however, shows the finish line, where tax-free returns may come in well ahead of flashier taxable investments.

"When you see your whole financial picture, as you do on a return, the effect of your income tax bracket becomes much clearer," says CPA Kenneth Powell of New York. "For a high-earning doctor, municipals paying 'only' 5 percent are the equivalent of taxable bonds paying 8.3 percent. And on lines 8a and 8b of your return, you declare all your taxable interest right next to the tax-free kind. So if you see that there's too much of the first type, you may want to reconsider your holdings."

While you're considering the virtues of tax-free investments, look for tax-free opportunities in unexpected places, such as money-market funds. Even doctors who think they're alert to tax-free investments often miss out here, McGrath says. "On some doctors' returns I see income from $20,000 or more kept in a taxable money-market account. Somehow, they don't realize that those cash accounts can be tax-free, too."

Still, tax-free doesn't necessarily mean problem-free. "You do need to be careful when choosing municipals," observes Powell, "because certain types can help throw you into the jaws of the dreaded alternative minimum tax." (We'll go into more detail about the AMT later.)

Are you missing out on a way to keep your retirement funds intact?

If you're a soloist and report your practice income on Schedule C, check whether you've been deducting a fee for management of your qualified retirement plan. If you haven't, presumably the brokerage is charging the fee directly to the plan. That's not wise, notes O'Connor. "When you decrease plan money, you lose out on tax-deferred growth."

What should you do? Unfortunately, you can't reimburse the plan; Uncle Sam considers that a further contribution. Instead, run things differently in the future. "Your practice should write a separate check for that fee, which should be a deductible business expense," O'Connor says. "Some brokerage houses require that the fees be deducted from within their accounts. In such a case, we set up an additional brokerage account—separate from the retirement plan—and the practice puts into it just enough funds to cover all the fees."

Are you losing money by stumbling over trading rules?

If you analyze your Schedule D investment gains and losses carefully, you may find you're making your trades more taxable. "That's especially likely if you're day trading," notes Powell, "because investors often get tripped up by the rules that effective brokers normally pay attention to."

One example is the "first in, first out" rule. Say you buy 100 shares of a stock at 20 a share, and then an additional 100 shares at 30. Later, you sell 100 shares at 80. If you sell the pricier shares first, your gain is $50 a share. But if you don't document the sale correctly, then on your Schedule D you'll have to assume that the shares sold were the first ones bought, and your gain per share will be $60.

To avoid investment mistakes, though, you have to watch several rules at once, warns CPA Ronald Helle of Dubuque, IA. Sometimes, selling the later, more expensive shares can be the wrong move. Suppose the cheaper, older shares were held for longer than a year, and the others were not. The gain on the first batch would be long term and taxed at 20 percent, but on the second it would be short term and taxed at your regular rate. In the top bracket, your tax per share will be around $20 (40 percent of $50), instead of $12 (20 percent of $60).

Now add in further complications: Stocks sometimes insist on going down, not up. You may have multiple sales, too, involving various lots and issues.

Moral: If you find such mistakes, consider firing your broker—especially if the broker is you. But don't assume that working with any pro will avoid such problems, cautions Gregory Goergen. "Brokerages may not keep track of separate lots, so find out whether your broker can really handle all of your record-keeping requirements."

Are you cheating yourself in your capital gain calculations?

On Schedule D, neatness can count—the wrong way. Do you list some nice round numbers there, under the cost of investments sold? That may be a bad sign. "When I see such figures on a return as the cost basis of an investment," says Goergen, "I suspect that the taxpayer's paying too much tax." The reason: You may not be adding in some numbers that typically aren't rounded, such as reinvested dividends, brokerage fees, and commissions. By omitting those, you understate your cost and overstate your taxable gain.

If you spot this on your return, change your tactics. It may not be hard to avoid this sort of mistake, says Baldassari. "When you sell holdings, check with the brokerage house or fund company. Their computers can often give you the exact documentation you need." You may have to pay extra to get a fuller report, adds Gregory Goergen. "But ask about it; the cost may be minimal."

Are some investments tax-inefficient?

If your investments are costing you too much at tax time, maybe you should re-evaluate them. The typical culprit: mutual funds that throw off big gains. "I'll often see those on a doctor's return," says Sidney Blum, a CPA in Northbrook, IL. "Maybe the doctor is really happy with the fund's performance and ignores the fact that the fund's management frequently recognizes big gains, which are passed on to investors." Worse, Blum adds, often a doctor will reinvest all the dividends in the same fund, which compounds the problem—literally. "As an alternative, you can certainly invest those dividends in some of the top tax-efficient funds."

Instead, maybe it's simply time to get rid of the tax-inefficient holding. "Your one-time gain from the sale might do less damage than the repeated annual cost of holding on," says CPA Sherman Doll of Walnut Creek, CA. Indeed, he adds, it might be better just to give the investment away to a qualified charity. That way, besides getting a charitable deduction, you'd avoid any tax on the gain.

Are you carrying forward investment interest expense you could be using?

Investment interest expense—like margin cost—is deductible, but many doctors have margin accounts, yet can use little or none of this deduction. That's because it's usable only against investment income (including capital gain), and since physicians are often heavily invested in growth stocks, they may have very little dividend income or recognized gains.

But maybe you can do something with that investment expense next time around, suggests Mary McGrath. The key lies in reversing a usual strategy. Generally, you don't want to take gains until they're long term, because long-term gains are taxed at a lower rate. But with such expenses, you might find an advantage in using short-term gains against them. "If you sell some appreciated holdings to realize a short-term gain, that gain can be neutralized by your investment expenses," she says. "Then you can buy the same holdings back. Net result: You have the same investment, bought at a higher cost, which means less future tax liability." (A "wash sale" rule does prohibit certain sell-and-replace tactics, but it doesn't apply to sales that result in a gain, McGrath notes.)

Couldn't you try this with long-term gains also? No. A net long-term gain isn't considered investment income. Sure, you can choose to treat it that way, and then you could deduct that investment interest expense. But there's a catch: If you do, you'll pay your ordinary tax rate on the profit, rather than the capital gains rate.

Are you in danger of the alternative minimum tax?

Does your return show a big deduction for state taxes? Or for home equity debt that's used for "nonresidential purposes," such as paying off car loans? Are you claiming accelerated depreciation on any investments? Then you may be subject to the alternative minimum tax calculation, a fiscal bogeyman designed to catch folks who are living a bit too large, tax-wise, under the usual deduction rules. Get hit by the AMT, and you lose the right to take these and certain other deductions for the year in question. That is, you get socked for more tax.

If you're in the AMT danger zone (ask your accountant, because the warning signs aren't always easy to spot), pay careful attention to the problem as the year progresses, warns Ken Powell. "In that case," he says, "consider paying some state taxes later, to push that deduction into a year when you might use it. In a high-tax state like New York, looking ahead this way could save you thousands." That's often true despite possible late-payment penalties from the state. But you have to run the numbers.

Are you taking full financial advantage of your relatives?

Does your return list a couple of lovable exemptions? Maybe you're not getting the most tax benefit out of those "family values." We're not talking about shifting income to a lower bracket simply by handing children investment assets, though that can be useful for kids 14 or over. We're talking about paying your kids to work.

Each child can earn up to $4,400 absolutely tax-free. "Also, earning money will qualify your child to establish a Roth IRA, which allows savings of up to $2,000 a year," says CPA Ronald Helle. "And the earnings in a Roth, if withdrawn after age 59¹/₂, are tax-free."

In addition, if your kids work for your practice, their wages reduce your own income tax, because they're another deductible practice expense. Wages paid by a parent to children under age 18 are exempt from payroll taxes, too, notes Helle, so if your practice is a sole proprietorship or a partnership owned by you and your spouse, you'd save a bit there also.

Could you justify paying young kids, if questioned? Gregory Goergen says you can. "I'd have no problem paying my 14-year-old daughter to do filing," he says. "Kids that age can do real office work, and do it well."

What about your spouse?

Does this year's return show that your spouse earned money from your practice? If not, maybe next year's should. "A spouse being paid by your practice is earning money that can qualify for Social Security benefits—and that spouse can also become eligible for deductible practice travel and fringe benefits," Helle notes.

Of course, your spouse must be doing real work, for a reasonable salary. And there must be a direct benefit to your business, observes Goergen. But if the situation passes muster, he adds, it offers another advantage: Paying that salary may also increase your family's nest egg appreciably. "For example, suppose your practice has a Simple IRA retirement plan and you pay your spouse $6,500. That spouse qualifies for the maximum Simple IRA deferral of $6,000."

 

Brad Burg. Hidden in your 1040: Solid financial advice. Medical Economics 2001;6:40.