Online tax tools make it easy for the average person to file their annual tax returns, but there are many scenarios where more sophisticated tax strategies can save a significant amount of money, making the ROI on personal tax advising very worthwhile for high earners with complex financial situations and those with sudden windfalls.
Tax advisors possess the experience to understand the massive U.S. tax code in order to help you avoid penalties and take advantage of tax breaks that the most non-professionals likely wouldn’t recognize. Certainly, you can do your own research and make your own Excel sheets to calculate certain tax scenarios, but you will find that tax law is dry and time consuming to parse. Tax regulations are constantly changing, and it’s difficult to quickly identify and keep up to date with which laws are most applicable to you.
Tax planning, outside of the traditional tax preparation (annual filing), when done correctly, is something that happens before and after major financial events, such as large purchases or major changes in your compensation. Below are some questions that may help determine whether you’re outgrowing TurboTax. Have you:
- Received K-1s from investments or partnerships, or income from an S corporation?
- Generating 1099 income and are uncertain about your deductions, retirement contributions, etc.?
- Been subject to alternative minimum tax (“AMT”) in past years or potentially subject to AMT this year?
- Received or exercised stock options this year? Sold a portion or all of your shares this year?
- Also, do you need to file estimated taxes with the IRS at the end of each quarter?
This happens if your tax liability exceeds what your employer withholds by a certain threshold. Otherwise, tax penalties will apply when annual tax returns are filed. Even if you work a traditional W-2 job, you may have irregular income, or what the IRS classifies as irregular “income” from paper gains when exercising stock options.
TurboTax and Self-serve Tax Software Limitations
There are a few key scenarios (among many others, per Intuit) in which TurboTax cannot address the filer’s needs, or make it more likely that there will be errors in the filing.
In general, online tax tools are not particularly well suited for non-standard additional needs, even if those additional needs can be very expensive if done incorrectly or overlooked.
Not supported by TurboTax:
- Complex K-1s: From investments in funds and partnerships
- Cross-state Filings: Individuals earning income from work completed in several states
- Permissible Expenses: If generating wages in the form of 1099 income
- QSBS: Sale of Qualified Small Business Stock for business owners or investors.
- International Tax Exposure: Allocating any foreign earned income, foreign rental income, transactions with foreign trusts, or moving expense reimbursement/allowance.
- Inheritance: Retirement plan distributions received from anyone other than the taxpayer’s own or spouse’s IRAs.
- Carried Interest: Treating carried interest as short-term capital gains for a 3-year period instead of a 1-year period.
Not supported well by TurboTax:
- Distributions from Multiple Types of Retirement Plans (Pension, Annuities, IRA, 401(k), Profit-sharing, etc.): Each type is considered a separate distribution, and requires separate 1099-Rs.
- Business Taxes and Credits
- Complex Itemized Deductions: Non-cash charitable contributions, multiple state sales tax, performing arts business expenses, etc.
- Tax Credits: Particularly for complex single/joint situations for divorced or divorcing filers with dependents.
- Unfamiliar Tax Situation Changes: For example, an individual not used to filing as a single member LLC
Example Scenario: Saving Hundreds of Thousands of Dollars in Federal Taxes with QSBS
As an example, a startup founder that takes advantage of QSBS (Qualified Small Business Stock) tax treatment on a stock sale can potentially avoid paying federal tax on gains of up to $10 million or 10x his or her tax basis, whichever is larger (the tax basis for this purpose is equal to the amount of cash plus the fair market value of any property contributed to the corporation in exchange for the stock).
It’s likely that the only interesting part of the previous sentence is the “avoid paying federal tax on gains of up to $10 million”. Everything after that is based in technicalities.
As shown in the table below, the tax savings can be substantial; however, many requirements must be met prior to qualifying for QSBS treatment. You need to receive shares in the company when it still has gross assets of $50 million or less and you must hold the shares for at least 5 years, among other requirements.
A good tax advisor can help guide you to make sure you meet these requirements and file the necessary paperwork, as well as flag other tax provisions that may be relevant to your needs.
|Example Buy and Sell Scenario||With QSBS Treatment||Without QSBS Treatment|
|Investment to Exercise||$500,000||$500,000|
|Sale Price (After 5 Year Holding Period)||$50.00||$50.00|
|Proceeds from Sale||$5,000,000||$5,000,000|
|Federal Taxes on Long-Term Capital Gains (Assuming 20% Rate)||$0||$900,000|
|Proceeds Net of Taxes and Initial Investment||$4,500,000||$3,600,000|
For a delta of $900,000 on your tax bill, it would be well worth paying a tax firm a few thousand dollars to make sure it is done correctly.
Tax Planning for Life Events
Aside from actual tax returns, a tax advisor can also add value by helping you make tax advantaged moves in key areas like retirement, estate planning, investment management, charitable giving, and small business planning.
Additionally, major life events, like a marriage, the birth of a child, or buying a home can also be scenarios where filers could leave money on the table if they don’t consult with a professional tax advisor. A good tax advisor should be able to help you tax optimize the entirety of your finances for all stages of your life.
- Tax Planning vs. Tax Preparation: What’s the Difference?
- Advice on Startup Liquidity Mistakes from AJ Wealth