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The Hidden Value in Scrutinizing Clients' Tax Returns

For most Americans, April marks the beginning of warmer weather as the chilly winter months fade into the past. The month also brings a sigh of relief for millions of Americans who complete the often painful process of filing their income tax returns by the April 15 deadline.

It’s tempting, of course, to stash personal copies of completed tax returns away with other documents and instead set one’s sights on the coming summer months. Yet for advisors, ensuring that clients are having an appropriate portion of payroll withheld for taxes can be an important step in the financial planning process.

With that in mind, analyzing completed tax returns should be a crucial aspect of assessing clients’ financial health. More specifically, there are two potential mistakes that clients can make when establishing how much of their paycheck is withheld for taxes—either setting aside too little or too much.

Clients who don’t have sufficient taxes withheld can face Internal Revenue Service penalties when filing their returns. In addition, clients may have to struggle to come up with cash needed to pay their outstanding taxes when filing their returns. Needless to say, in such cases, advisors should help their clients calculate appropriate tax withholding rates to avoid the penalty.

The second possible mistake is having too much withheld from paychecks. Many Americans deliberately do so to qualify for a large tax refund each year. They argue that the strategy is a form of forced savings. Yet, it’s also a costly strategy as investors miss out on investing the money during the months leading up to receiving their refunds.

To that end, advisors should be prepared to illustrate the costly nature of excessive payroll withholdings. One powerful illustration involves making 401(k) contributions with money that would have otherwise have gone to making excessive payroll withholdings. Assume, for example, that a 30-year-old client with a $100,000 annual salary starts allocating 10% of earnings to his or her 401(k) plan. With a 50% employer matching contribution on the first 6% of deferred income and annual 3% salary increases, the client can potentially accumulate a $2.6 million nest egg by age 65, assuming a 7% annual investment return.

For sake of illustration, assume the same client has an extra $3,000, or $250 a month, withheld from payroll each year for taxes. If the client were to instead allocate that amount to monthly 401(k) contributions, the nest egg would potentially grow to more than $3 million.

At the same time, the client would enjoy reduced taxes as 401(k) deferrals are typically done on a pre-tax basis. Some clients may intend to make a lump sum payment into individual retirement accounts or annuities when they receive their tax returns. By holding off on making the retirement savings contributions until they receive their refund, they can better assess if they will need the money for other unexpected expenses.

Yet, such a strategy can be problematic. Choosing an IRA or annuity purchase can result in foregoing company matching contributions that would occur if the assets were diverted into an employer-sponsored retirement plan. In addition, a delay in investing the money means that the assets will have less time to grow.

That can be a significant mistake if equity markets generate strong returns in the months leading up to the arrival of a tax refund check. Investors who choose to make a lump sum deposits, furthermore, miss out on the benefits of dollar cost averaging that occur when regular payroll contributions to retirement plans are made.

The concept of dollar cost averaging involves buying equities on a routine basis. By making routine allocations to equities, stocks will be bought when equities are approaching a peak and at other times equities will be purchased when markets have declined. It can be appealing because it can help clients avoid making large purchases of equities during market peaks.

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