Many firms instruct their advisors not to give tax advice. While a few advisors strictly adhere to this policy many give advice if they feel it is a simple question to answer. Unfortunately, this can lead to very poor outcomes due to unforeseen cascading effects of how taxes are calculated. Here is a simple example.
John and Mary are a retired couple, both age 67. They each have an annual Social Security benefit of $30,000, each are distributing $20,000 from their IRAs annually, and they have a non-qualified stock portfolio generating $20,000 in annual dividends.
John and Mary come to their advisor and tell them they want to withdraw an additional $10,000 from John's IRA so they can take a cruise. Their advisor asks them if they want to withhold taxes. They say they do. Their advisor looks at their previous year return and determines their taxable ordinary income was well within the 12% bracket so he withholds $1,200 federal. John and Mary live in Colorado, which has a flat tax rate of 4.5%, so their advisor withholds $450 state income taxes. John and Mary receive a net distribution of $8,350 and they happily go on their cruise.
Everything is fine until tax time. They expected to owe nothing because they instructed their advisor to withhold taxes. If they do their own taxes they will be shocked that they owe an additional $2,568 in federal taxes as well as $265 in state income taxes. They will probably assume they have made an error and will most likely call their advisor for help figuring out what went wrong. Their advisor probably won't have any answers for them.
Their next step may be to contact a tax professional to make sure they haven't made an error. The tax preparer verifies that their tax liability is correct. They ask the preparer how they could owe more in tax when their advisor withheld taxes on the additional distribution, and that distribution was the only thing that changed from the previous year.
Their tax preparer will explain that two things have happened to increase their taxes much more than expected. First, more of their Social Security became taxable. Without the extra $10,000 distribution $45,100 of their benefits would have been added to taxable income. The additional distribution caused another $5,900 of their benefits to be taxable, increasing their ordinary taxable income by $15,900, not the $10,000 as expected. By the way, they are still in the 12% bracket.
The second thing that has happened is, due to the increase in federal taxable income, $12,400 of their qualified dividend became taxable at 15%. Without the additional distribution their taxable income was under $80,800, so none of it would have been taxed. Their tax preparer is most likely going to tell them that their financial advisor gave them very poor advice - permanently destroying the advisor's credibility. The tax preparer probably has an advisor he can refer John and Mary to if they want someone more competent in taxes - he might even be a licensed advisor.
Had their advisor been a Tax Acuity subscriber, all of this could have been avoided. It would have taken their advisor about five minutes to determine what their actual withholding on the $10,000 distribution needed to be. After the federal and state withholding, John and Mary would only receive $5,517 - probably not enough to cover the cost of their cruise. They may decide it is better take some money out of savings, if they have any, or to sell a little of their stock rather than take in IRA distribution.
Tax Acuity is priced at $59.00 per month. If you can avoid just one of these mistakes each year, it is well worth it. You can take a free 10-day trial of Tax Acuity by clicking the button at the top of the page. Don't let easily avoidable tax errors disappoint your clients.
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