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Are you trying to learn how to deliver massive tax value to your clients? Then look no further. Retirement Tax Services Podcast, Financial Professional’s Edition is a show hosted by Steven Jarvis, CPA. Steven aims to bridge the gap between tax professionals, financial advisors and their mutual clients in their quest for reducing tax expenses in retirement.
Welcome to the Retirement Tax Services Podcast! Steven’s guests Monday were Phillip Christenson and Jim Sexton of Phillip James Financial. At one point, they described taxes outside the traditional federal income variety as “shadow taxes.” The phrase was an instant hit.
These oddities sneak up on you during tax planning. Today, Steven is shedding light on them. In other words, he’s focused on how you can keep them away from clients.
The IRS doesn’t officially recognize the term. Regardless, “shadow tax” has become a favorite expression around Retirement Tax Services.
We don’t have time for a truly exhaustive list, but Steven’s highlighting the most common. In fact, he’ll show you how to anticipate them.
Take a quick review, first: Adjusted Gross Income (AGI) and Modified AGI will come up a lot. Look for AGI on Line 11 of a 2020 Form 1040. It’s calculated from lines 1-10.
AGI represents all of your income. When people talk about “above the line” adjustments, this is what they mean.
The benefit of above-the-line adjustments is that they can be used to reduce the amount of income taxed. At the same time, they lower the base amount from which shadow taxes will be assessed.
AGI and modified AGI wind up being the same for some clients. However, they won’t be the same for everyone. As a result, it’s important to know which threshold a possible shadow tax is based on.
Meanwhile, the IRS has multiple definitions of “Modified AGI.” So, the credit, deduction, or tax can vary the calculation.
Note that various amounts have to be added back to AGI to determine the modified AGI. These can include foreign income (and housing) exclusions, IRA contributions, and student loan interest.
Non-taxable social security payments may factor in, as well. Passive loss or passive income and rental losses can impact it, too. Don’t worry, though: You don’t need this committed to memory.
The goal is to keep building your knowledge base. In other words, you just need to know the potential trouble spots to double check. Likewise, be ready to tell clients, “Here’s an area we need to consider,” when discussing a strategy.
Having tax-planning software for running projections is great. Working with your client’s tax preparer to run draft tax returns helps, too. Both can help ensure your accuracy. Nonetheless, learn the basics of what to watch out for, firsthand.
Remember that a taxpayer’s AGI is tied to several tax credits and deductions. The level at which your AGI starts impacts these is based on your filing status. The IRS has tables to show when and how credits and deductions are phased out.
Child and Dependent Care Credits are commonly affected by the AGI. Similarly, deductible charitable contributions and deductible medical expenses are, as well. For 2020 and 2021, Covid19 stimulus checks figure in, too.
Many of these are opportunities people miss out on when their AGI goes up. True to their name, shadow taxes impact a bill from outside of the client’s brackets and marginal tax rate.
When Steven says “marginal tax rate,” he is referring to the rate at which the next dollar of income will be taxed. Sometimes this also affects other deductions or credits.
Modified AGI is used to determine multiple things. This includes things like whether or not someone can make deductible contributions to a retirement plan. Similarly, it affects things like whether or not they can contribute to a Roth account and more.
Learn to shed further light on shadow taxes in this episode of the Retirement Tax Services Podcast.
Thank you for listening.
Steven Jarvis :
Hello everyone and welcome to the next episode of the Retirement Tax Services Podcast: Financial Professionals Edition, I’m your host, Steven Jarvis, CPA, and in this show, I teach financial advisors how to deliver massive value to their clients through retirement tax planning. On Monday’s episode, I had a great interview with Jim Sexton and Phillip Christiansen of Phillip James financial. They shared their experience and insight from years of doing tax planning, as well as tax preparation for their clients. So they have some really great background with taxes in financial planning.
One of the things that stood out to me from that conversation and perhaps my new favorite tax terminology is when they mentioned shadow taxes. Now shadow tax is not an official IRS definition, but I loved how Jim and Phil used it. They were referencing taxes other than the traditional federal income tax that we typically think about. So these are taxes that go beyond your marginal tax rate. They can be things that sneak up on you when you’re working with clients on tax planning strategies, and definitely things you want to be aware of.
So nothing blows up on you come tax preparation time. So today I want to dive a bit more into what some of those shadow taxes are and things to be on the lookout for, to know whether they are potentially an issue. Like so many things in tax this will not be an exhaustive list because we don’t have the time, and honestly, the attention span to go through every possible scenario. But I’m going to give you some of the common shadow taxes to be on the lookout for.
We need to start by defining a couple of terms that get used with multiple of these shadow taxes: adjusted gross income and modified adjusted gross income. On the 2020 form 1040, adjusted gross income or AGI is reported on line 11, on the first page of the 1040. It’s calculated from lines 1 through 10 of the 1040, and essentially represents all of your income, less certain adjustments.
When people talk about ‘a6ove the line adjustments’ related to taxes, adjusted gross income is the line they are referring to. And the value of an ‘above the line adjustment’ is that in addition to reducing the amount of income that is taxed, it also lowers this amount that is used in determining some of these shadow taxes. For some people AGI and modified AGI end up being the same amount, but it’s important to know which threshold a shadow tax is based on because there are situations where the numbers will be different. It’s also important to note that the IRS has multiple definitions of modified AGI. So depending on which credit deduction or tax we were talking about, the calculation of modified AGI can vary. So some examples of amounts added back to AGI to get to modified AGI in these different situations are: foreign income and housing exclusions, IRA contributions, student loan interest, non taxable social security payments, passive loss, or passive income and rental losses.
Like I said, that definition of modified AGI does vary, so you need to know which area you are looking for. So, while modified AGI and AGI can be the same number for certain taxpayers, there are differences. Like we’ve talked about on other episodes, the goal of going into this much detail, isn’t for you to commit it all to memory, but to keep building your knowledge base of things so that you can at least say, ‘Hey, I think that’s something we need to double-check.’ Or, ‘Here’s a potential area that we’ll need to consider, as we implement this strategy.’ Having a tax planning software, you can use to run tax projections, or working with your client’s tax preparer to run draft tax returns are definitely great ways of ensuring accuracy in these areas. But again, we at least want to give you the information so you can kind of raise that, that yellow flag or that red flag to say, that hey, there might be another issue to consider here.
Okay. So we’ve defined AGI and modified AGI. Let’s talk about these different shadow taxes and how they’re related to these amounts. So, a taxpayer AGI is tied to several tax credits and deductions. The level of your AGI that starts impacting these credits and deductions is based on your filing status, similar to tax brackets. So, the IRS has tables that you can go and look at, that show you when and how the credits and deductions are phased out. Common examples of areas potentially affected by your AGI are the child independent care credits, how much of charitable contributions are deductible, how much of medical expenses are deductible, and hopefully unique just to 2020 and 2021, how much of the COVID-19 stimulus checks you are eligible for. So while we are lumping these all under this new favorite label of shadow taxes, you can see as we go through this, that many of these really are opportunities you miss out on as your AGI goes up, as opposed to an additional tax at a specific rate. But either way it impacts your tax bill and is outside of what we normally focus on, which is that those tax brackets and a client’s marginal tax rate.
Now, before we shift to modified AGI, let’s talk for just a second about marginal tax rates. Marginal refers to, the next one. So when we were talking about marginal tax rate, we were talking about what rate will the next dollar of income be taxed at? It’s important to keep in mind that it’s not always as simple as – you are in the 24% tax bracket, so the next dollar of income will cost you 24 cents in taxes. It’s possible that the next dollar of income also impacts other deductions or credits and can have a bigger impact than just that marginal tax rate in whichever bracket you fall in.
Okay. So let’s talk about what modified AGI impacts because for many clients, this list can be the more impactful one. So modified AGI is used to determine things like whether you can make deductible contributions to a retirement plan, whether you can contribute to a Roth account. Whether you are eligible for the premium tax credit under the affordable care act; this is a big one where that next dollar of income can have a much bigger impact than just what your marginal tax rate is at a particular time. Whether you will be subject to the net investment income tax; this is one of the few areas that we’re talking about that really is an additional tax with a specific percentage. So as opposed to just limiting your ability to take advantage of a deduction or a credit, the net investment income tax is that additional 3.8% tax that some taxpayers are required to pay on investment income that goes above and beyond their ordinary or capital gains rate. Modified AGI is also used in determining the child tax credit you are eligible to receive and education credits that you’re eligible to receive. All right, so deep breath, that’s a whole lot of information and a lot to keep track of. So, like I said before, this is, let’s expand our knowledge base and know what things we should be on the lookout for as opposed to committing these all to memory.
For our RTS members, we are working on a condensed reference guide to make these shadow taxes a lot easier to go back and reference, have some of those thresholds in there. So, you know what you’re on the lookout for, but none of this is proprietary knowledge. You can certainly go out and find resources and information about these different things that you should be keeping in mind as you work with your clients. Some of you might be listening to this and thinking all the more reason to leave taxes to tax professionals, but really I disagree. With so many, many nuances and exceptions, your client is going to be better off if they have a team of people looking out for them throughout the year and not just a single checkpoint up against a deadline each year. Like we’ve talked about before, the models are just different for tax professionals versus financial advisors and financial advisors are quite often in a better position to be aware of the things that are going on in a client’s life throughout the year, and especially to identify changes that might be coming.
And even if there are things that the tax preparer also will identify, cause there’s lots of great tax preparers out there. Advisors often can identify them earlier in the year and help more proactively address any of these issues, especially if there’s concerns, to help a client know what to expect and to prevent surprises. I think this is a topic that reinforces that your role really should be to help uncover opportunities and then work with the client and their tax preparer to make sure these topics get addressed correctly and timely. Even if, maybe especially if you work with clients or who tax DIY-ers, and don’t have a tax preparer in their life, you have a great opportunity to be a second set of eyes for them not to guarantee that your review means that there can’t possibly be an error or an exception on their tax return, but to help them identify where there might be things to consider and potentially to help them identify when their situation has gotten complex enough, that they should consider working with a tax preparer.
To help this list feel a little less daunting. I’d recommend that you start making notes of which of these areas you commonly see with your client base. Especially as you refine your niche, you will find that some of these credits and deductions or taxes are more common with your clients than others, and that’s where you should focus your time and attention. So, instead of trying to commit all of these topics to memory and learning the specific thresholds for each, because of course they all have different thresholds when they start applying or start phasing out, you can focus in and get comfortable with the ones that do apply to your clients. So for example, if your clients consistently run into issues with the net investment income tax, you can take the time to get comfortable with the thresholds for that. So that you’re confident saying to a client that for single filers, the threshold is $200,000 compared to, married filing separately at $125,000 and married filing jointly at $250,000.
Right? So instead of going down this whole list and committing them all to memory, you can pick up those ones that, you know you’re going to be talking about on a regular basis. So, because I know you’d be disappointed if this wasn’t the main action item, I talk about, make sure you are getting tax returns for every client every year, especially as we look at today’s topic, I’m going to recommend that in addition to reviewing individual client’s returns, so you can better work with them… on a personal level, you should also be looking for and making notes of themes you see across your clients. So you knew where to focus your efforts in learning more about specific tax topics. Reviewing client tax returns is also the best way to see which of these deductions credits or taxes have been applicable to them in the past. So again, you can narrow your focus of what might be relevant going forward so that you don’t feel like you need to sit down with a client and go through every item on this list that we talk about, but that you can get into more detail on the ones that might actually be relevant to them.
All right. Thanks for hanging with me through this episode. As we got into the weeds on some of these things, I hope this was helpful until next time. Good luck out there, and remember to tip your server, not the IRS!
The information on this site is for education only and should not be considered tax advice. Retirement Tax Services is not affiliated with Shilanski & Associates, Jarvis Financial Services or any other financial services firms.