Today one of my colleagues at Abundo Wealth, Maggie Klokkenga, CFP®, CPA, shares some of the key things she is looking at when reviewing a client’s tax return. She provides a checklist to help you review your own tax return and uncover some of the stories your return can tell.

Take it away Maggie….

Taxes – The Story of Our Lives

I like to say that your tax return tells a story about your life. Reading that story is one of my favorite parts of the financial planning profession as both a CFP® and CPA. 

When you spend time looking into the details of a tax return, you can learn about family members, kids in college, what kind of business someone owns, how much they earn, whether they bought or sold a home, even if they had some gambling winnings, and a great many more things about what happened to them in last year’s chapter of their story.

Sometimes, what you see in that story are opportunities for improvement or discussion. This is important because taxes can be such a big and hidden annual expense item!

Do you have a good grasp on your Form 1040? Here are a few places we immediately look as financial planners. This checklist might help you to unlock some savings and grow your after-tax wealth.

Are you getting hit too hard by taxes on dividends?

Where to look: Form 1040: Lines 3a, 3b

If you have a taxable brokerage account, it is normal and expected to have some dividend income to report. But when the dividend numbers look high relative to your investment balance, that can indicate a significant optimization opportunity.

A total US stock market index is an example of a tax-efficient index fund. Its current dividend yield is a little less than 1.5%. Imagine you had $100,000 in taxable investments, all in the US stock index. You would expect roughly $1,500 in dividends. All would be qualified (Line 3a = Line 3b).

If you have $5,000 in dividend income with a $100,000 balance in your brokerage account, that’s a tip off that you might be holding tax-inefficient funds. This is especially true if the dividends are mostly non-qualified (Line 3a < Line 3b).

Non-qualified dividends are taxed at your ordinary income rate. They usually come from fixed income securities like bond funds, real estate funds, and some international stock funds. The solution is usually to revise the asset location strategy.

Are you paying more than you should in capital gains taxes?

Where to look: Form 1040: Line 7 and Schedule D

Just like some dividend income is normal, some capital gains can be normal if you sold shares of your funds. But if you hold actively managed funds, you might be getting hit with hidden capital gains!

Active funds are notorious for creating capital gains. This is a result of buying and selling stocks within the fund. The issue is that those gains are passed along to the investors as taxable income. Index funds, on the other hand, rarely generate capital gain distributions.

On the opposite side of the tax spectrum, you may see a $0 capital gain (meaning you are avoiding the active fund risk above). That can also indicate a potential opportunity!

If you own shares in your taxable account that are currently at a loss, capturing $3,000 of that loss through the process of tax loss harvesting could save you money on next year’s tax bill. You can also build up a pot of losses over time (called carryover losses). You can use these losses to reduce taxable income for many years to come.

Did you take advantage of IRA accounts?

Where to look: Form 1040: Line 10 & Schedule 1

One interesting quirk about traditional 401(k) and 403(b) contributions is that they don’t actually show up on your tax return! That money is withheld from wages. It only “shows up” by lowering the starting point of the wages you enter.

Traditional IRA contributions, however, do show up directly on the tax return. Those are entered in Schedule 1, Part II (Adjustments to Income). They flow through to Line 10 of the 1040. If you are eligible to make these contributions but we don’t see them on the form, we know there’s a potential opportunity to discuss!

Some people prefer Roth IRAs instead. In that case, the contribution will not appear on Line 10 because a Roth IRA doesn’t reduce taxable income. (Note: it’s still a good idea to track your Roth IRA contributions on your own so you know how much of the balance is from contributions vs. earnings. This is a key determinant of penalty-free early withdrawals).

Did you take advantage of the Backdoor Roth IRA (for higher earners)?

Where to look: Form 1040 Lines 4a/4b and Form 8606

How about higher earning folks who utilize the so-called “backdoor Roth IRA” method? Well, in that case, what they’ve actually done is make a non-deductible traditional IRA contribution (shown on Form 8606) and a subsequent conversion to a Roth IRA. If we see a high earner who doesn’t have a Form 8606, we know a backdoor Roth might be in their future! 

We also double check that the process is being executed correctly. Use Form 8606 along with the first page of Form 1040.

There should be no taxes due. If there are, that indicates either a wrong selection was made, or you have existing traditional IRAs (which need to be rolled into a workplace retirement plan to enable the backdoor process).

Did you take advantage of Health Savings Accounts (H.S.A.’s)?

Where to look: Form 8889

This one is fairly straightforward. If you have access to an H.S.A., then there’s a very good chance you should be taking advantage of it due to its triple tax-protected status.

If we don’t see Form 8889, we know there’s a potential opportunity! But even if we do see that form, there are still a couple things worth looking at.

The first thing is how much was contributed? Was it the annual maximum? If not, we’re definitely going to have a conversation about whether it’s possible to increase that amount. We may decide the current contribution is okay based on the person’s situation, but we want to at least have that conversation. 

The second is were there any distributions from the account? Again, this might be completely appropriate if you need the cash flow. But if you have the liquid funds to pay the medical expenses, there might be a much better strategy available to you – paying out of pocket and keeping the receipts!

There’s no time limit on using old receipts to make tax-free withdrawals. Ideally that distribution will be $0 if you’ve still got a long investment horizon and the cash flow to cover expenses without using HSA funds.

Related: How We’re Using Our HSA In Early Retirement

Did you pay the right amount throughout the year?

Where to look: Form 1040: Lines 34, 37 & 38

The IRS uses a ‘pay as you go’ system. This means that you are responsible for withholding money from each source of taxable income when that income is paid to you.

If you end up with a large refund (Line 34), that means you withheld too much throughout the year. You’ll likely want to withhold less going forward so you get access to your own money sooner.

On the other hand, if you withheld too little, then you’ll see the amount you owed at tax time on Line 37. Owing some money at tax time isn’t necessarily a problem – unless you owe a lot!

When you owe a large amount, that can trigger an underpayment penalty. That’s extra money that you owe on top of your tax bill because Uncle Sam didn’t get paid on time. If you have this penalty, it will be easy to spot on Line 38.

Related: Do I Need to Pay Estimated Quarterly Taxes In Retirement?

Are you leaving low tax bracket space on the table?

Where to look: Form 1040 Lines 11 and 12

Wait, is the question asking if I could be paying MORE in taxes? Sometimes, yes! 

Especially for the early retiree community, we sometimes see extremely low adjusted gross incomes. I’ve seen as low as $2,000! 

That can actually be a significant mistake if you have pre-tax retirement accounts. At a bare minimum, it almost always makes sense to withdraw from tax-deferred accounts or convert to Roth accounts enough money to fill up the 0% bracket (via the standard deduction). 

It often makes sense to do the same with the 10% or even 12% brackets. Obviously this is very situation-dependent. Typically you can take advantage of these low brackets while maintaining a low enough taxable income to keep ACA premiums manageable or avoid IRMAA if you’re on Medicare.

Don’t let those low brackets go to waste! They are a use-it-or-lose-it proposition in low income years.

Conclusion

Investing can be really simple when you follow a buy-and-hold index fund strategy. Taxes are not quite as simple. But with a little bit of smart planning, you can reduce the amount you owe the IRS and improve your after-tax earnings.

Even if taxes aren’t your thing, it’s worth learning these fundamentals of the tax return so you can make sure you’re not missing any low hanging fruit opportunities.

And I hope you come to enjoy the story the tax return tells! If you open up your 2023 return, what is it telling you?

Related: Early Retirement Tax Planning 101

* * *

* * *

[Chris Mamula used principles of traditional retirement planning, combined with creative lifestyle design, to retire from a career as a physical therapist at age 41. After poor experiences with the financial industry early in his professional life, he educated himself on investing and tax planning. After achieving financial independence, Chris began writing about wealth building, DIY investing, financial planning, early retirement, and lifestyle design at Can I Retire Yet? He is also the primary author of the book Choose FI: Your Blueprint to Financial Independence. Chris also does financial planning with individuals and couples at Abundo Wealth, a low-cost, advice-only financial planning firm with the mission of making quality financial advice available to populations for whom it was previously inaccessible. Chris has been featured on MarketWatch, Morningstar, U.S. News & World Report, and Business Insider. He has spoken at events including the Bogleheads and the American Institute of Certified Public Accountants annual conferences. Blog inquiries can be sent to chris@caniretireyet.com. Financial planning inquiries can be sent to chris@abundowealth.com]

* * *

Disclosure: Can I Retire Yet? has partnered with CardRatings for our coverage of credit card products. Can I Retire Yet? and CardRatings may receive a commission from card issuers. Some or all of the card offers that appear on the website are from advertisers. Compensation may impact on how and where card products appear on the site. The site does not include all card companies or all available card offers. Other links on this site, like the Amazon, NewRetirement, Pralana, and Personal Capital links are also affiliate links. As an affiliate we earn from qualifying purchases. If you click on one of these links and buy from the affiliated company, then we receive some compensation. The income helps to keep this blog going. Affiliate links do not increase your cost, and we only use them for products or services that we're familiar with and that we feel may deliver value to you. By contrast, we have limited control over most of the display ads on this site. Though we do attempt to block objectionable content. Buyer beware.