RTS #044 “Whatever makes the taxes needs to pay the taxes.”

So long as taxes are paid on-time (remember this is quarterly, NOT just April 15th), the IRS generally does not care from where the taxes are paid. Client psychology however can care, a lot.

Let’s use a specific example for retired clients taking both regular IRA distributions and receiving Social Security.

By default, taxes are NOT withheld from Social Security as it requires a separate form (W-4V). As such, most clients are receiving tens of thousands of dollars of partially taxable income without any taxes being withheld. As noted above, the IRS doesn’t care, so long as enough is being withheld elsewhere and/or being paid in quarterly estimates.

This creates one (or both) of two problems:

Estimated Payments: To make up for the underwithholding, most tax software will simply recommend making quarterly estimated payments. While we have an entire guide on how to best approach estimated payments, a far better approach is to eliminate the payments all together, thus reducing the headache to clients.

Overwithholding somewhere else: Advisors who understand the hassle of estimated payments and/or who want to make sure clients don’t owe in April often solve this issue by increasing withholdings from IRA distributions. While this satisfies the IRS, it creates a perception issue that the portfolio is generating less income than it actually can, as the client only really thinks about the NET distribution, not the gross. In other words, it feels like the portfolio is doing a poor job, when in reality, it’s carrying more than its fair share.

The solution? “Mr & Mrs Client, it’s our philosophy that whatever creates the tax bill, pays the tax bill. Currently it appears that while your Social Security is creating thousands of dollars in taxes each year, your portfolio is the one paying that bill. As such, I recommend we make a small adjustment to your withholding by completing together this Form W-4V”.

Will this change help the client pay less in taxes? No. Will it potentially give them a better tax experience? Yes, which in some cases can be equally as important.

Happy Tax Planning!