Tying Form 1040 to potential tax-managed opportunities

Many advisors are having great success in gaining new clients with taxable assets. Some reasons for this success are:  1) U.S. equity markets are materially higher coming out of 2008, 2) tax rates went up for many investors, and 3) taxable distributions from mutual funds have been trending upward the last several years. Advisors often ask how to identify clients that may be paying too much in taxes or identify where tax pain points may be for investors.

One of the best ways is a quick review of the client’s Form 1040. The client’s tax advisor may have a specific plan for what you see in a 1040 and should be taken into consideration; below we’ve highlighted some of the ways you can forensically go through the 1040 with a view towards investment-related taxes. Note that none of the items highlighted suggest something is “good” or “bad” in regards to investment choices, but it does highlight where the investor is seeing taxable income resulting from their investment decisions. We find that investors (and many advisors) don’t appreciate how much tax they are paying due to their investments.

The Form 1040

Looking through an investor’s Form 1040 can yield lots of good insights in regards to investment-related taxable income. There are many other schedules and tax forms related to investments activities (Schedule B, Schedule D, Schedule E, etc.), but at some point, all of these flow through the Form 1040.

Form 1040

For illustrative purposes only. Line 8a: Taxable interest.

  • If you have an investor with more than $1,500 in dividends or interest, they will likely file a Schedule B to itemize their interest and dividends.
  • Line 8a equals the total received from taxable interest income. This will include interest paying vehicles like savings account interest and interest earned from taxable bonds and taxable bond funds.
  • Note that taxable interest is taxed as ordinary income and is taxed at the highest marginal rate of 43.4% (39.6% + 3.8% Net Investment Income Tax, which is the tax on unearned income tied to the Affordable Care Act) for taxpayers in the higher tax brackets.
  • What is the after-tax yield on this interest income? Is this amount in line with helping to meet long term financial goals?
After-tax yield = pre-tax yield x (1 - marginal rate)

? Tax Check: Does the client understand the amount of taxes being paid on the interest? Perhaps consider municipal bond funds as either a replacement or complement to the current interest paying accounts.

Line 8b: Tax-exempt interest income

  • Interest income from municipal bonds and municipal bond funds is reported here. This interest is generally tax-free at the federal level.

? Tax Check:  Is this interest subject to the AMT (Alternative Minimum Tax)? Note that interest from private activity bonds are generally tax free at the federal level, but they are typically taxed for AMT.   Make sure you understand the character of the tax-free income.  The Form 1099 will provide this information.

Line 9a: Ordinary Dividends

  • Again, if you have an investor with more than $1,500 in dividends or interest, they will likely file a Schedule B to itemize their interest and dividends.
  • Line 9a equals the total amount of dividends received. This information is typically gathered by investors and their accountants using Box 1a on Form 1099-DIV.
Line 9b: Qualified Dividends
  • Line 9b equals the total amount of dividends that are considered as “qualified dividends” received from individual stocks and mutual funds. This designation is found in Box 1b in Form 1099-DIV. For dividends, recall there are two types to evaluate in regards to taxes. The difference can be material in regards to taxes.
    • Qualified Dividends: Generally, dividends paid from U.S. companies structured as corporations are considered qualified. Foreign dividends can be considered qualified as well if the issuer is incorporated in a U.S. territory or the U.S. has a tax treaty with the country in which the issuing firm is based.
    • Non-Qualified Dividends: This category includes pretty much all other dividends. Examples include dividends from entities that include real estate investment trusts (REITs), master limited partnerships (MLPs), dividends paid on employee stock options, dividends paid by tax-exempt companies, and dividends paid on savings or money market accounts.

? Tax check:  Why does it matter?

  • Qualified dividends are treated as long-term capital gains and currently taxed at 20% for those in the top tax bracket. Add in the 3.8% Net Investment Income Tax and the top rate is 23.8%.
  • Non-qualified dividends are taxed as ordinary income and will be taxed at the investors top marginal tax rate. For those in the top bracket, that is 39.6% + 3.8% Net Investment Income tax for a total of 43.4%.
    • Non-qualified dividends are taxed 82% higher than qualified dividends. This difference can greatly impact the after-tax return.

Line 13: Capital Gains

  • Gains from Box 2a of Form 1099-DIV. This is where capital gains from mutual funds will be reported or summarized by the broker for underlying securities.
  • If the investor had no capital loss carryforwards to report and sold no capital assets, they’re generally good just using Line 13 on Form 1040. If not, they get the pleasure of using Schedule D.

Form Schedule D:

  • This schedule feeds line 13 on the Form 1040 and broadly covers the sale of capital assets during the year (broken out as short term and long term) and the reporting of capital loss carryforwards.

? Tax Check: Is there an inordinate amount of buying and selling securities/funds relative to the size of the account? This higher turnover may be leading to increased taxes. A more thoughtful tax-managed approach may provide an improved after-tax return.

The bottom line

A little knowledge from looking through your clients’ completed Form 1040 can provide a great deal of information about investment-related taxes. Your conversations about investment-related taxes coupled with their tax advisor’s plan for what you see in the 1040 could be beneficial for your clients. At the very least, it shows the client that you are doing everything you can do to help them retain more of what they have earned through their investments.