Using form 1040 to identify financial planning needs.

Form 1040 is virtually unsurpassed as a road map to a client's financial needs, as well as a vital blueprint for developing financial planning goals. Without the information provided on this form, a financial planner would have to invest much more time and effort to identify a client's financial imperatives: for example, a young family's concern about college funding, a middle-aged couple's need for business capital or an older client's worries about having adequate retirement income and reducing the size of their estate.

However, form 1040 is only a tool for identifying opportunities; considerable analysis usually is necessary before any recommendations can be made. This

article describes how to use a client's form 1040 to identify financial planning needs and how to take advantage of an opportunity to complete a financial planning engagement for the client.

MINING THE 1040 CHECKLIST

A checklist such as the one on page 63 can help the planner pinpoint areas needing attention while prospecting for financial planning clients. Each category should elicit a series of questions to be raised with the client that might, in turn, reveal issues to be addressed in a financial planning engagement.

Information as minor as a change of address can prompt financial planning concerns. If a client has moved since his or her last return was filed, there's a perfect opportunity to ask if property and casualty insurance, tax and estate planning issues have been addressed since the move. Residence in a new state may require new wills. The new residence also should be properly insured and withholding may need to be adjusted to reflect the deductions a larger mortgage may bring.

After thoroughly reviewing the data on form 1040, the planner should schedule an initial conference with the client to assign priorities to specific financial planning goals. This can be done most effectively by reviewing line by line those form 1040 entries the planner has found to be of concern. Using graphics or computer-generated schedules should be avoided at this point. The objective is not to impress the client with financial wizardry but, rather, to develop a comprehensive personal financial plan in a series of segmented planning engagements.

ANALYZING FORM 1040 DATA

What kinds of form 1040 entries should raise red flags? While some entries are obvious, such as excessive taxable investment income for a high-bracket taxpayer, others (inadequate diversification, for example) may not be as easy to spot. A few examples follow.

High taxable income. The client's schedule B shows a large amount of taxable interest or dividend income. Is this income needed to cover family living expenses? Is the client in the top marginal tax bracket? Unnecessary taxable income may indicate a need to rearrange the client's investment portfolio. Investments that generate tax-exempt or tax-deferred income may be more appropriate. Investments also can be restructured to emphasize long-term growth if additional income is not needed to supplement wages.

Consider the Smiths, a retired couple with a significant federal income tax liability. Their principal income source is interest on bank certificates of deposit (CDs) and oil and gas royalties. Itemized deductions on schedule A are minimal; they have no mortgage on their home and medical expenses are reimbursed by Medicare and private insurance. A conversation with the client reveals current income exceeds the amount needed for living expenses.

Under these circumstances, asset reallocation could help the client diversify and reduce taxes. For example, transferring a part of the couple's assets to a single-premium deferred annuity will reduce the size of the estate subject to probate and the amount of income subject to current taxation; the couple will be able to make withdrawals from the annuity as needed and pay tax on that income only when they do so. CDs don't offer such flexibility. If the Smiths receive Social Security retirement benefits, up to half may be subject to tax under current law. If form 1040 shows they pay tax on these benefits, proper planning to rearrange their investments may also reduce or eliminate the tax. Diversification. Form 1040 also may reveal an overconcentration of assets in one area. This may include substantial dividends from only one stock (for example, that of the wife's employer), interest on a single bank account or undue reliance on risky investments such as those in commodities or oil and gas.

For example, the Smiths' schedule B shows all their liquid assets are invested in CDs. This leaves them vulnerable to purchasing-power risk--the risk inflation will erode their purchasing power over time--and interest rate risk-exposure to short-term interest rate fluctuations.

These problems can best be solved by using asset allocation techniques to diversify in accordance with their risk tolerance and goals.

For the Smiths, repositioning part of their assets into tax-exempt municipal bonds will not only diversify their investment portfolio but also reduce their taxable income. If further diversification is desired, an investment in equities (individual stocks, mutual funds, etc.) may be an appropriate move.

Insufficient diversification also may mean the client lacks a well-defined investment philosophy. Additional work may be needed to determine whether the client's current investments match his or her goals, objectives, risk tolerance and tax bracket. The client may need a new investment adviser or broker to provide investment guidance.

Cashflow problems. Cash flow problems also may become apparent when reviewing a client's tax return. Consider the case of Mary Jones, a self-employed taxpayer who had a large balance due when her return was filed, plus penalties for underpayment of estimated tax. This situation presents a number of planning opportunities:

* Does the client understand the estimated tax rules? A simple explanation may help avoid future penalties.

* Does the client need a cash flow analysis? Cash inflow may be adequate (the client earns enough to live) but she may need help with budgeting and the timing of expenditures (her business income may be cyclical).

* Will asset reallocation reduce the client's overall tax liability and improve cash flow? Investments can be structured to provide Jones with adequate income during slow business periods.

Jones's self-employed status creates other planning opportunities. For example, is a sole proprietorship or partnership the best form or organization for her business? Would a C or S corporation be better (and perhaps even solve her cash flow problems)? In either case, does Jones take maximum advantage of the employee benefits each ownership form offers? Opportunities exist to help clients establish retirement plans to reduce taxable income and fund future income needs.

Education funding. Funding their children's education is a concern of many clients. Does form 1040 show deductions for dependent children? If the practitioner was not asked to prepare a return for the children (which means little or no income-generating assets have been placed in the children's names), it's likely the family could benefit from income shifting to fund future education expenses.

When a completed 1040 was delivered to Carol and Mike Martin, the clients said they already had started an education fund for their five-year-old son. About $2,000 was invested in a passbook savings account. An analysis of future college costs, however, showed current funding provisions were inadequate. The planner recommended they begin a monthly investment program for each child (they also have a daughter, age 3). Because of the children's ages, a growth mutual fund was selected as the investment vehicle.

For many clients, the excuse for not prefunding education expenses is a lack of available funds. Does line 61 show a refund? A refund of almost any size can be used to begin a savings program for education or retirement. A large refund may mean withholding or estimated payments need to be reduced (making the resulting increase in monthly take-home pay available to continue meeting savings goals).

Insurance. Form 1040 can yield a wealth of information about a client's insurance needs. Obviously, clients with children need adequate life insurance. Of course, home and car owners should have property and casualty insurance. But what about disability insurance? If only one W-2 is submitted with the return, meaning only one spouse works outside the home, does he or she have the disability insurance needed to protect the family? Even if the other spouse is able to work, it can take time to find a job and restore family income to previous levels.

Retirement. A client's tax return and accompanying data can reveal a great deal about how he or she has prepared for retirement. A form 1040 shows any contributions to an individual retirement account (IRA), Keogh or other retirement plan. Form W-2 shows any contributions to an employer's 401(k) plan and whether the employer provides a pension plan. Planning opportunities abound. Has the client explored 401(k) distribution options? How much retirement income will existing provisions provide? Does the client contribute the maximum amount to his or her 401(k) plan? Depending on the answers to these questions, the client may need additional retirement guidance, even if he or she is young. An opportunity to provide it shouldn't be missed.

ESTATE PLANNING

Clients whose forms 1040 show substantial income often have sizable taxable estates to back it up. The various income sources indicate the types of assets they own; for example if both spouses receive a salary or other income from an S corporation, they are likely to have an ownership interest in a closely held business. This opens up considerable estate and business succession planning opportunities.

Consider the situation of Bill and Betty Baxter. Their 1040 shows each drawing a salary from EZ Widgets, an S corporation. Their answers to the questions on the tax return checklist suggest they need help redrafting their wills to take advantage of recent estate tax changes, implementing a buy-sell agreement for their closely held business and adopting an irrevocable life insurance trust. If such S corporation income is not scrutinized to prompt additional questions, an engagement opportunity may be missed.

Delivering a completed tax return to a client presents an opportunity to ask whether he or she has an up-to-date estate plan (including a will, trust, power of attorney, etc.). A computerized estate planning program can be used, with the client seated at the planner's side, to explore alternatives for disposing of his or her estate. Such alternatives often are difficult for the client to understand, and computer-generated illustrations showing estate distribution and the tax effects of each alternative make it easier for him or her to select the best option.

Reviewing a client's schedule A provides a good indication of his or her charitable inclinations. If charitable donations are substantial, the client may benefit from more sophisticated charitable giving strategies, including charitable lead or remainder trusts, gifts of appreciated property, etc. In addition to the income tax benefits, certain estate planning goals also may be met. For larger gifts, schedule A also shows what charities the client favors. Many such charities have their own planned-giving programs with income and estate tax benefits.

COMMON MISTAKES

Many tax returns will show common mistakes and may indicate the client needs the help and direction of a financial planner. For example, a tax return may show the client failed to

* Roll over a retirement plan distribution he or she did not need when changing jobs.

* Match capital gains and losses in the same tax year. (For example, last year's return shows a large gain and this year's return has a large loss that will have to be carried forward.) Perhaps the client did not even consider the tax consequences of disposing of assets.

* Make an IRA contribution even though his or her employer does not offer a pension plan.

* Prepay state and local taxes. This could result in penalties or, at the very least, postponement of the deduction's tax benefit.

* Take advantage of all available itemized deductions. While this is not an immediate planning opportunity, it suggests the client needs help maximizing income and deductions and minimizing taxes. The key to turning tax return clients into financial planning clients is developing relationships. It's important to remember that clients don't need to have personal relationships with their tax preparers, but they do need to have close working relationships with their financial planners.

EXECUTIVE SUMMARY

* FORM 1040 IS VIRTUALLY unsurpassed as a road map to a client's financial planning needs. Planners can use form 1040 to identify opportunities to complete a financial planning engagement for the client.

* A CHECKLIST OF QUESTIONS can be used with tax return clients to identify additional financial planning concerns. A follow-up conference can be scheduled to determine the need for additional work.

* A CLIENT'S TAX RETURN can reveal problems such as unnecessary taxable income, inadequate diversification and poor cash flow. Form 1040 also can indicate a need for education funding, an insurance coverage review and retirement planning.

* SUBSTANTIAL INCOME ON form 1040 often means there's a substantial estate backing it up. When delivering a completed tax return to a high-income client, the planner should ask whether he or she has an up-to-date estate plan in place.

* A TAX RETURN ALSO SHOWS common mistakes that usually point to the need for a financial planner. Mistakes include failing to roll over unneeded retirement distributions, failing to make individual retirement account contributions and mismatching gains and losses.

Tax return checklist for identifying financial planning needs

Investment planning

* Does investment income suggest a concentration of investments in one area? * Does the investment mix appear appropriate considering the client's stage of life and capacity for financial risk? * Does investment income suggest a liquid fund has been established for emergencies? * Does the number of capital gain and loss transactions indicate excessive trading? If so, does the client need a coordinated investment plan? * If a family-owned business exists, is there a succession plan that will reserve the business value and provide liquidity?

Cash flow planning

* Given the number of family members, does the level of income appear sufficient to provide for necessities plus a suitable amount of savings? * Does the level of investment income demonstrate past successes in accumulating savings and managing cash? * Is investment income increasing or decreasing? Does a decline suggest a net cash outflow? * Do schedule A interest and debt service represent an acceptable percentage of income?

Education funding

* Does the tax return show there are children in the family? * Do the children file tax returns pointing to the establishment of education funds in their names? * If funds previously have been transferred to children, does the client understand the consequences of making gifts in trust versus making outright gifts? * If there is a family-owned business, are working-age children receiving wages?

Risk management

* Does the taxpayer's occupation require special coverage? (For example, a surgeon may need disability insurance that pays when he or she is unable perform his or her own occupation.) * Is family income dependent on one wage earner? * Do the number and ages of dependents suggest income continuation needs are likely to high in the event of death or disability? * If the tax return shows ownership of rental property or schedule C income, does the insurance expense appear reasonable in relationship to the property's value? * Are there extraordinary medical expenses? Do the expenses indicate inadequate health insurance coverage or special needs? * If the client receives Social Security benefits, has he or she elected coverage under part B of Medicare?

Retirement planning

* Does form W-2 or schedule C list coverage under retirement plans? Does the client make maximum contributions and deferrals? * Does the level of wages suggest the client is likely to qualify for the maximum Social Security retirement benefit? * Does Form 8606, "Nondeductible IRA Contributions, IRA Basis, and Nontaxable IRA Distributions," indicate a prior accumulation of IRA investments? * Considering age, accumulated investments and level of debt, does the client appear to be on track toward funding retirement income?

Estate planning

* Does the amount of income on the tax return point to a sizable taxable estate? * Do the clients have wills? Trusts? * Will the $600,000 exemption equivalent be wasted on the first spouse's death by on excessive concentration of joint wealth? * If a closely held business is part of the estate, is a buy-sell agreement needed? * Does the estate have sufficient liquidity? * Is life insurance, if any, properly structured to remain out of the estate?

MICHAEL R. RUFF, CPA, PFS, CFP, is a sole practitioner in Pampa, Texas. He is a member of the American Institute of CPAs and the Texas Society of CPAs.