PERSONAL FINANCIAL PLANNING

February 2000

USING A CLIENT'S 1040 TO BEGIN THE FINANCIAL PLANNING PROCESS

By Michael David Schulman, CPA/PFS, Schulman & Co.

One of the biggest mistakes that taxpayers and their accountants make is treating the 1040 as simply a compliance vehicle used to fund the U.S. Treasury. Most taxpayers give their returns a cursory examination and file them away. Perhaps they will be needed for a loan or financial aid application. Other than that, they are likely to be ignored.

In reality, a tax return is an excellent point at which to begin the personal financial planning process. Few taxpayers prepare financial statements other than their tax returns, so they are often their only comprehensive financial documents. Additionally, clients might feel threatened if asked to complete a lengthy financial planning questionnaire. Starting with an already prepared document is easier on the taxpayer and a natural transition to the financial planning process.

Using the Return

The following are points to consider in reviewing Form 1040 for financial planning ideas:

Dependents. Dependents are usually the children or parents of the taxpayers. For dependent children, consider education planning and the need to fund future tuition costs. Ask whether the taxpayers have a will: They should have one that names a guardian for the children even if they do not have a taxable estate. If they have a dependent parent, ask similar questions about how they are paying for the parent's support. Does the parent need nursing home care? Can the parent purchase insurance to defray some medical costs?

Wages and Salaries (line 7). (Please note: line numbers are from the 1998 1040.) Are the taxpayers funding any employer-sponsored 401(k) or cafeteria plans? This is especially important when the employer provides a generous match of contributions. (In what other way can a taxpayer obtain an immediate return on her investment?) Do the taxpayers have adequate disability coverage to protect against loss of earning power?

Dividends and Interest (lines 8a, 8b, 9). Ask taxpayers if they are satisfied with the returns on their portfolios. Discuss the portfolio's diversification. If the return shows a lot of CD interest, diversification may be in order. Evaluate the taxability of the portfolio--is more tax-exempt income an appropriate objective?

Alimony Received (line 11). Spouses receiving alimony often need cash management assistance and help with budgeting. If the spouse is home with children and is unable to undertake full-time employment, assistance in finding adequate health care coverage might be needed.

Self-employment Earnings (lines 12, 17). Discuss the advisability of incorporating the business or forming a limited liability company to protect personal assets. Is the business properly insured? As with wage earners, is there adequate disability coverage? If a taxpayer is using her home for business purposes, will her homeowners' insurance provide adequate coverage? If she has employees, does she also provide workers' compensation and disability insurance for them? Look at the bottom of page 1--is there a deduction for a retirement plan? If not, discuss retirement savings with the taxpayer. (Perhaps a new SIMPLE plan may be appropriate.) If so, is the funding adequate?

Capital Transactions (line 13). If the return shows substantial losses, perhaps it is time for a professional portfolio manager or investment advisor. Frequent trading may be a sign that the taxpayer is not planning for the long-term. Are unrealized holding gains and losses being properly used in her portfolio? Has an appropriate strategy been developed for the use of loss carryforwards?

IRA and Pension Distributions (lines 15, 16). Inquire as to why the taxpayer is taking distributions. Many distributions are taken to satisfy short-term cash needs. Perhaps the taxpayer needs a short-term line of credit. If the distributions are normal distributions, discuss the amount. Is the minimum distribution calculated correctly? Review the beneficiary designation. Are the beneficiaries still correct? Or, has a remarriage been overlooked?

Rent, Royalties, Partnerships, and S Corporation Income (line 17). Discuss the nature of the taxpayer's investments. If there are unusable losses, should the investment be sold? (Caution: Usually the basis will be zero because depreciation deductions have been taken.) Should the taxpayer acquire an interest in a passive income generator (PIG) to offset losses from other investments? If so, does the PIG have economic substance?

SEP/IRA Deductions (lines 23, 29). Is the taxpayer eligible for a deductible IRA? If so, is a deduction taken? Again, now is the time to discuss retirement planning. Inquire as to a spousal IRA. Recent legislation greatly expanded the deduction for a spousal IRA (from $250 to $2,000). Is the taxpayer happy with the retirement plan? Review asset allocation.

Overpayment (line 65). Many taxpayers anticipate a tax refund. It is probably better to decrease withholding and invest the difference, perhaps in 401(k) plans. Why make an interest-free loan to Uncle Sam?

Medical Expenses (Schedule A lines 1­4). If the client has deductible medical expenses, review the medical coverage. Also, remember the premiums for long-term care insurance are now deductible.

Interest Expense. Even though personal interest is no longer deductible and therefore will not appear on Schedule A, inquire about the taxpayers' debt condition. If there is excessive credit card debt, suggest taking a home equity loan to repay it.

Charitable Contributions (lines 15, 16). In lieu of cash contributions, is there appreciated stock that could be donated to avoid the capital gain while achieving charitable objectives?

By spending a few minutes reviewing tax returns, you can greatly increase the services you provide to your clients. This could lead to both an increase in billable fees as well as a better and more intimate relationship with your clients. *