It’s on my return, but what does it mean?

Ben (00:06):

Welcome back to the Retirement Tax Podcast. I’m your humble co-host. As always, Benjamin Brandt, joined by the illustrious Steven Jarvis. Steven, how are you doing today?

Steven (00:14):

Ben, I’m doing good. Feeling illustrious and ready to go.

Ben (00:17):

I love it. I love it. So what are we talking about this week? We’re talking about interesting things that we found on our tax returns.

Steven (00:24):

Yeah, specifically this really comes from this recent tax filing season we went through. I always like to pay attention to the common questions and common themes I’m getting from taxpayers because I do this stuff all the time. I look at hundreds of tax returns every year. It can start to kind of feel pretty common place to me, but when somebody only looks at one tax return a year, a lot of this stuff still feels kind of confusing and out of place. And so there were a couple of themes that kept coming up that I thought would be good for us to talk about because Ben, I think that there’s some of these that you’re probably creating for clients as well, that you probably do a better job than most of talking about how these things work. But often there’s things that can come up on a tax return that a client might think, Hey, wait a second, is that even right? That can’t possibly apply to me.

Ben (01:08):

Alright, that sounds good. So what would our first example be of things that I spotted on my return and it looks like a red herring, it looks like it doesn’t belong. 

Steven (01:16):

So probably the one that I get the most shock from of clients saying, wait a second, no, that can’t possibly be right, is foreign income tax. And so really how this normally comes through on a tax return is a foreign income tax credit because the IRS will give US taxpayers a credit. There are some limitations around this, but just concept of if you’re paying taxes to a foreign country on income that’s also getting taxed in the United States, you can get a credit for the tax you paid to this foreign country. And so why this comes up as a shock to people is they say, Hey, wait a second, I don’t do anything in foreign countries. How in the world do I have a foreign tax credit?

Ben (01:54):

It almost sounds like fraud. I didn’t do any work that I’m aware of in Europe this year, but yet I have some foreign tax credit from X, Y, Z. So it looks unusual.

Steven (02:06):

And what can add to the confusion or that feeling of, Hey, this is out of place. Sometimes it’ll come through with a specific country like it says, Hey, you have a foreign tax credit for taxes paid in Sweden or Germany, and sometimes it just says various, which to me sounds even more concerning to say, wait a second, I paid this odd dollar amount to what country is various, what language do they speak there? But when it comes back to it, the answer I give to taxpayers when this comes up because it comes up a lot, cause I’m not the investment guy, and I tell ’em that. I say, Hey, I’m not the investment guy, but we see this all the time with our clients who are working with a financial advisor to have a diversified portfolio. Honestly, that’s about the extent we need to go to because especially if they’re working with a great advisor, that’s usually enough for them to kind of bring back that recollection of, oh, that’s right. I remember my advisor talking about whatever this might look like in my portfolio. I just didn’t realize that it was going to come through on my tax return. So Ben, maybe give us a little bit of insight from that investment side as to why someone might have this foreign piece, even though they don’t specifically remember saying, Hey, why don’t we go invest in Sweden?

Ben (03:07):

So our investment philosophy is kind of a three-legged stool. So we want to buy the best companies in the world. We want to own them as cheaply as possible and hold them as long as possible. And so the best companies in the world are in the entire world. So there might be pharmaceutical companies from different countries. There might be technology companies from different countries. So if we want to have a truly diversified portfolio, we’ve got to reach beyond the United States, maybe not for a huge position of our portfolio, maybe not like half, but maybe in some cases it’s like 10 or 11% In many portfolios where we have an international piece, you can own it through mutual funds, ETFs, individual stocks, mutual funds, index funds, you name it. But yeah, there’s lots of reasons to own companies that reside outside of the US for additional diversification.

Steven (03:51):

Probably what makes this a little bit more confusing or frustrating for taxpayers is there’s not really great consistency or even transparency as to what exactly this is going to mean on your tax return. Because there might be listeners thinking, well, hey, wait a second, I’ve got an international component, but I don’t remember seeing this foreign tax credit you’re talking about. And that might be totally true and accurate. It’s not going to be across the board. It’s going to depend on the type of investment, whether that investment is paying dividends. There can be a lot of different factors as to whether or not this is going to come through on your tax return. And for most people, we’re not talking about huge dollar amounts if we’re just talking about foreign tax credits off of an investment portfolio. Usually, this is in the dozens of dollars, maybe hundreds of dollars. We’re not talking about thousands or tens of thousands of dollars for most people. And so thankfully the reporting happens pretty automatically that this is going to come through on your 1099 from your taxable brokerage account. It’s going to get input into your tax return even if you’re DIYing your tax return, usually it’s pretty straightforward of how this gets input and reflected on your tax return.

Ben (04:52):

I suppose another version of that would be at like an ADR. Have you ever seen ADR that would be a foreign company that you’re buying on a US stock exchange? So I guess there’s different versions of that. Yeah, if it’s in your IRA, you’re probably not going to see that because it’s going to be covered by IRA distributions. That is reported differently. Most of clients, I mean all of our clients are retired and most of them have IRAs. Very few like brokerage, non-qualified accounts. I think we have 80 clients and 250 accounts. I think we have less than 10 non-qualified accounts. So it’s not something we come across too often, but it’s definitely something that has come up in the past.

Steven (05:27):

Yeah, that’s a good distinction you make there, Ben. It’s going to be dependent on the type of account we’re talking about because it’s specifically we’re looking at taxable investment accounts because if it’s in an IRA, it’s in a whole different category of how it’s taxed. If it’s in a Roth IRA, we’re not going to get taxed on it at all. Yeah, there can be some different factors there. So I guess more of the overarching point of this conversation is if you have investments and you’re seeing a small amount of foreign income tax credit come through on your tax return, there’s no need for concern. There’s no need to worry that you’ve fallen subject to some kind of scam overseas where you’re supporting some prince warlord in a foreign country.

Ben (06:02):

Now, Steven, is this process fairly automated? What if I think I’m owed a federal credit for foreign tax, but I don’t see it, like you mentioned it, I know I have investments in a Swedish chocolate company, but I don’t see anything on my statement. How would we know if we’re owed one and it doesn’t happen automatically with the tax filings?

Steven (06:23):

That’s a really good question, especially if we’re talking about indirect investments through mutual funds or ETFs or something we’re doing through any kind of custodian. My first recommendation would be that you reach out to the advisor you’re working with or the custodian that you’re on because that is a fairly automated process. That shouldn’t be something that you as the investor, as the taxpayer need to do a bunch of legwork to figure out. Especially I see this come up most commonly just with where I’m at in the clients I work with. I see this come up at times with people who worked in Canada move to the US, even if they’re now US residents or US citizens, that if you have Canadian retirement income, that is something different than what we’re talking about right here of having a mutual funder, an ETF with a foreign component. And at that point, you might need to dig a little further or work with someone who specifically works on international tax issues. So if you have direct investments in other countries or you decided that buying a home in the Swiss Alps was just what you had always dreamed of and now you’re going to rent it out for part of the year, that’s a different story than what we’re talking about here, and you probably need to have a more intentional approach to how that gets addressed.

Ben (07:23):

Excellent. So that’s foreign tax, foreign income tax credits. What would be some other examples of maybe some unusual things that we might be seeing on our tax return?

Steven (07:30):

Another one that comes up kind of in a similar vein is what’s called the qualified business income deduction or QBI is what that’s more commonly referred to. And again, this will come as a surprise for taxpayers who see this and say, well, wait a second, I don’t have a business. I’m not self-employed. Just even if they don’t know much about the deduction, the fact that it says business in it and there’s a separate form in the tax return for it, this can come as a bit of a surprise. And again, they have this question of, wait, did something go wrong? Again, this can be fairly common depending on what we’re invested through a taxable brokerage account in particular, there’s certain types of REITs or real estate investment trusts that will kick out dividends that qualify for this QBI deduction. And so what I often tell clients is that similar to the foreign income tax credit, this is something that’s being handled by the investment manager or the investment custodian as far as the reporting and tracking of all these things. And there’s a fairly small amount of QBI and a tax return. I’m not going to get real hung up on it. I’m going to double check to make sure that there is some kind of taxable investment account with these REITs in it, and then we’re going to move on. Thankfully we don’t have to do a lot of extra legwork, but again, we wanted to bring it up here just so that we can kind of take away that moment of panic of, oh crap is something wrong on my tax return.

Ben (08:44):

So it could be something that we’re not thinking about. It’s not a red flag that it’s some kind of an error, but a good idea to probably look into these things, but maybe we can save you the trip if we’re explaining it here.

Steven (08:54):

Yeah, absolutely.

Ben (08:55):

Excellent. What might be some other examples?

Steven (08:57):

It’s a little bit different from what we’ve been talking about, but for me falls under this category of what can we know ahead of time to prevent some of the moments of panic at tax time? And since you and I talk about Roth-related things quite often, including Roth conversions, one that I see come up at times is misunderstanding how our tax bill works. And so a couple of related examples that came up this year were situations where a client had done a Roth conversion and then had a big balance due at tax time that they weren’t expecting because their advisor had helped them with withholdings on their Roth conversion or to help them make an estimated payment or maybe just the payment due was larger than they were expecting by a large amount. And so those were all situations I came across this year.

(09:40):

And the gut reaction from a lot of taxpayers, which logically makes sense, is, Hey, I did this thing that was different this year. I did this Roth conversion and now my tax return looks different than I expected it to. It must all be because of that Roth conversion. I must have screwed something up that was a terrible idea. Why would I have ever done that? And anytime we have those feelings, we really need to take a second and say, okay, wait, am I really seeing the whole picture? It’s altogether possible that we misjudged our estimate. We thought we were in the 22% bracket, we’re really in the 24% bracket. Maybe some of that went on. I’m lucky enough to work with a lot of great advisors who are really proactive doing these Roth conversions, and we don’t see that happen very often. More commonly what I see is that that’s just the largest piece and the thing that’s easy to point a finger at, we’ve got to make sure we’re understand the rest of the tax return.

(10:27):

So a couple of things that came up this year that led to that one was investment returns. It can be hard to predict at the beginning of the year what our investment returns are going to be. So if we had more capital gains or more dividend income that our sources of income that don’t naturally have tax withholdings, then yeah, we’re going to have more taxes due at tax time. And while that tax payment is never fun, it’s really for a good reason we made more money working with retiree clients, this can also come up when we have a new pension that kicked in or some other new source of income that by default again, doesn’t have withholdings taken from it. Maybe for a pension we can go back and ask for withholdings, but before we go into sheer panic mode, let’s take that moment to say, Hey, what else changed on my tax return this year?

Ben (11:08):

Yeah, that definitely resonates with me. When I think about times that I could have communicated more clearly with clients or around that year, we do a year-end tax planning meeting with every client usually between Halloween and Thanksgiving and when part of that is we want to guesstimate with our tax software as close as we can to what their year-end income is going to be. And then many times we’ll do a Roth conversion and then if they owe some taxes, presuming that they’re over 59 and a half, we’ll do a distribution just for withholding to try to avoid any penalties and things like that interest. And so by doing that at the same time as the Roth conversion, it might look like we’ve withheld 50% for taxes as part of the Roth conversion. And if we don’t explain it right, a client might say, well, geez, Roth conversions, you pay 50% in taxes.

(11:55):

That doesn’t seem like a good deal for me. So one thing that we try to work with clients on is just the idea, and I think maybe I learned it from you, Steven, if it makes the taxes, it pays the taxes. And so if clients sign up for their pension on their own or they sign up for social security on their own and they don’t do any withholding at all, especially with social security, like an extra step, and of course with the pension, it makes this payment smaller and nobody wants that. So then when we do the guesstimation at the end, it says, okay, we owe additional 5,000 in taxes and we withhold that as part of the Roth conversion. That is an instance where we probably could have explained that better to the client that we’re doing multiple things at once in order to hopefully avoid this other thing. So if it makes the taxes, it pays the taxes, I think a pretty good rule of thumb to avoid some of that confusion.

Steven (12:38):

I think I originally sold that from our good friend Micah, but it is something I really support because we run into this issue and you and I have talked about this before, where there’s balance between what really works in practice and then the perfectly mathematically optimal outcome of a thing. And so we can have all of these really nuanced discussions about where’s the perfect place to have paid the taxes from and should I justify that extra a hundred dollars to get just perfectly dialed in? That is one of the reasons you and I get along so well is that what we care about more is actually getting things done. And so if trying to get things perfect stands in the way of taking action that’s valuable, then I’m not going to focus on perfect. I’m going to focus on action and value. That’s not to say that we’re just going to throw out logic and reason just to do something, but let’s get close and get things done and not let perfection get in the way of getting something good done.

Ben (13:29):

Right. Yeah. I think on my other podcast before, I think I called it like a Roth conversion purist where I can’t possibly do withholding because that’s going to impact the total dollar month that goes into my Roth IRA. I’ve got to do a special quarterly estimate and pay those out of after tax sources because all the finance blogs, see, that’s the absolute perfect way to do it, but that’s so many extra steps when as long as we’re 58 and a half or older, we can just do the withholding. Your advisor can take care of everything and there’s no risk of us matching fill out the wrong form and it doesn’t get matched to the right quarter or whatever it is. Sometimes it’s the Occam’s razor of retirement planning and tax planning. Sometimes the simplest solution is the right solution.

Steven (14:13):

Absolutely. And then as we come back to these things, that’s the other thing I’ve been trying to focus on more recently, Ben, is in fact, I’m working with a group right now to write an article on this of the communication journey of a Roth conversion because especially if you read all the blogs and listen to podcasts like this one, a lot of people will only focus around the initial decision and they can do the mental acrobatics to make the math as pretty as possible, but that’s just one point in the journey. It’s an important point. We’ve got to make that decision and take action. Even if we’re DIYers, we need to have this conversation with ourselves or with our spouse, whoever else is involved when the decision is made, when it’s reported on our tax return later on down the road when we benefit from that Roth conversion.

(14:56):

And so if we’re doing Roth conversions now, we should take a moment in 2026 to when tax rates go up and now we’re having to take RMDs that are smaller and at higher tax rates than we’re locking in. Now, we should take that moment to say, Hey, this is why I did those Roth conversions. Or when we have that one-time expense, hopefully it’s for something fun like an RV or a trip to Europe, but might be because of a medical expense or a new roof to say, Hey, this is why I did that Roth conversion four years ago is so I had the flexibility to take that money now without getting killed on taxes. And so doing a Roth conversion is not a one-and-done activity. It’s this journey that needs to be reinforced and revisited.

Ben (15:32):

Absolutely. Yeah, absolutely. It’s not one-and-done. We got to come back to this all the time. And that’s kind of the tricky part too, that with Roth conversions especially, we’re doing guesstimate math because we don’t know what our portfolio values are going to be in 10 years. I used to say that we will know when we have to start taking distributions, but that’s changed I think three times in the last decade. So we don’t really even know that anymore. So there’s a good amount of guesswork going in, but I think it is valuable once we get there to look back and say, okay, I’ve got 500,000 in my IRA and 500 in my Roth, whereas when I retired, I had a million in my IRA and what would the difference have been? Because sometimes it’s good, especially if you’re doing it yourself to look and say, okay, that was a good choice that I made, and it reinforces other good choices that you’re about to make kind of giving yourself that attaboy or atta girl. So I think that’s a good idea.

Steven (16:19):

Well, Ben, and that just reminded me of one other thing I wanted to touch on. Just, Hey, we’ve got to revisit these things. We can’t, unfortunately, the tax code’s written in pencil, and so we can’t make our tax plan and then just assume it’s good for the next 10 years because something that recently came up as this episode airs, it’s several weeks ago now, but the IRS punted yet again on enforcing RMDs on inherited IRAs. Which we’ve talked about on this show. So I just want to reinforce that the message that we shared before doesn’t change just because the IRS is punting the rule doesn’t mean that your plans necessarily need to change. If you are a very high-earning professional in the last few years of your career and a few years from now, your tax rate’s going to go down because you’re going to have a couple of years before RMDs and social security kick in, then great, hallelujah.

(17:02):

The RMD got punted. You can wait before you start taking that inherited IRA distribution. But for most of us, we still want to look at that 10 year window and at a minimum start spreading it out over those 10 years as opposed to getting killed all in year 10. But really what we want to do is look at the life events that we can anticipate over the next 10 years and say, when does it make the most sense to do these things? We don’t want to let the IRS’s whims dictate how we do our tax planning.

Ben (17:28):

Yeah, that’s an excellent point. Yeah. Just because the IRS said you don’t have to, you might still want to, but that’s a great thing to, if you’re DIY investor, play a couple scenarios through your tax planning software. If you’ve got an advisor, call ’em up and ask them, I don’t have to take this distribution, but maybe should I, in a way, it’s almost like a Roth conversion. We’re intentionally paying more taxes now to pay less taxes later, and we’re just trying to find a, I don’t even want to call it a loophole, but it’s just an opportunity to give ourselves some flexibility where everybody hates paying taxes. So where we can, we want to pay less, where we can legally do so. 

Steven (18:02):

The tax code’s 80,000 pages long, and I try to look at that as 80,000 pages of choices we can make. Now, thankfully, we can look at our own individual situation and most of those pages aren’t applicable to us, and so we can just focus on the choices that are relevant to us. But we’ve got to look at tax planning as just a series of choices that we’re allowed to make.

Ben (18:20):

Stay tuned for Steven’s new checklist, 80,000 check marks long for the 2024 return. Perfect.

Steven (18:26):

Can’t wait to jump into that.

Ben (18:27):

Ben. And any parting thoughts for us today, Steven?

Steven (18:30):

I really enjoy having these conversations where we can give specific examples of things to just be mindful of, to be aware of, because as much as tax savings are my favorite part, when I can show someone that we’ve worked together to pay less than taxes, that’s a huge win. The other thing I really try to do is just make the tax experience less painful, and the more we can kind of pull back the curtain a little bit, understand a little bit of these things a little bit better and reduce that anxiety, the more we’re going to be willing to lean into tax planning and not look at taxes as this scary thing we should only touch once a year.

Ben (19:00):

For what it’s worth, Steven, our clients say that you make it significantly less painful, so we appreciate that. Happy to do it. Alright, so until next time, don’t let the tax man hit you or the good Lord split you.

Steven (Disclaimer):

Hi everyone. Quick reminder before you go. While Ben and I feel very strongly about the information we’re sharing on this podcast, it is for educational purposes only and should not be taken as specific tax, investment or legal advice. You need to make sure that you are working with a professional to evaluate how these concepts apply to your specific situation before you take action.