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I t is usually worthwhile to hire an accountant or other adviser for financial advice, and most serve their clients well. Unfortunately, even these pros may give advice that isn't suitable for a particular client -- or for any client. Here are some traps that advisers frequently let their clients fall into -- or even lead them into...
REAL ESTATE
Pumping up your mortgage. Your accountant might advise you to take out as large a mortgage as possible because the interest is tax-deductible. Even though it's deductible, mortgage interest must be paid, and payments on a large mortgage might leave you short of cash that you'll need elsewhere. You even could lose your house if you suffer a financial setback and find yourself unable to make the steep mortgage payments.
Some people take out extra mortgage money and plan to save or invest it, but the interest paid on a mortgage is usually greater than what you could earn on personal savings -- a gap that can eat up most or all of the mortgage's deductibility advantage. And it's not worth risking a big mortgage in the hope that you can use the borrowed money to earn more elsewhere.
INVESTING
Selling mutual fund shares improperly. Financial advisers often fail to tell their clients that selling fund shares wisely is not as simple as buying them.
To avoid paying unnecessary taxes when you sell all of your shares in a fund, you must tally up any dividends and other fund distributions that were automatically reinvested into the fund and count this amount as part of your "basis" (your cost for tax purposes). Your fund company usually can provide you with the numbers. Then you report your basis on your tax return, along with the amount you receive for the shares when you sell them. Including all of your reinvested distributions in your basis will help you by reducing your taxable gain or increasing your deductible loss.
Trap: If you acquired shares in the fund at different times and want to sell only some of those shares, you can specifically designate that your highest-cost shares be sold. This strategy will minimize your taxes.
How to do it: Write to your broker or the fund company (or have your adviser do so) before the sale takes place, and identify the shares that you would like to sell.
Example: "Please sell the 100 shares of ABC Fund that I bought on January 10, 2005." Keep in mind that any gain on shares held more than one year will be taxed at no higher than 15% federally. Gains on shares held for a shorter time will be taxed at your ordinary income tax rate, up to 35% federally. If you own both short-term-gain and long-term-gain shares, calculate the taxes you would pay in selling each, then sell the shares that result in the lowest tax paid.
Disposing of worthless securities without following the tax rules. If you invested in a company whose stock has lost all value, you can take a capital loss equal to your entire "cost basis" in the shares. But you must show that the company became totally worthless in the year for which you're filing a return. This may not be easy to do -- and many advisers fail to tell their clients that this proof of worthlessness is necessary.
Better: Sell the securities to a sympathetic unrelated party (someone other than your spouse, sibling, parent, child or business partner) for $1, which will enable you to take a normal capital loss without having to prove that the stock became totally worthless. You will probably want to reimburse your helpful friend for any transaction costs.
Alternatively, get a letter from your broker stating that the cost of selling the securities would be greater than the proceeds you would collect. This also enables you to take a capital loss.
TAXES
Prepaying estimated taxes. Some people must pay estimated taxes each quarter to their states, as well as to the IRS. The final payment for any given year is due the following January 15.
Historically, for people who itemize deductions, state estimated tax payments made in the previous December have qualified for a deduction that year on the federal tax return.
Trap: In recent years, exposure to the alternative minimum tax (AMT) has become more widespread. For people who owe the AMT, prepaying state tax can result in "wasting" a large outlay that won't be deductible.
Example: A hypothetical John Morgan, who lives in Buffalo, owes New York State a $5,000 estimated tax payment by January 15, 2008. His accountant tells him to send in a $5,000 check by December 31, 2007, to get a federal income tax deduction for 2007.
However, John winds up owing the AMT in 2007 -- and state tax payments aren't deductible under AMT rules. John gets no write-off for this $5,000. He would have been better off delaying the payment until 2008, when he might not owe the AMT.
Protection: Ask your accountant to consider the AMT before recommending year-end tax prepayments.
Taking unsupported deductions for alimony payments. This bad advice is commonly given to divorced people by advisers. The facts: For an alimony deduction to be valid, there must be a written agreement between the two parties spelling out monetary amounts and the rights and responsibilities of each party. Also, you can never deduct child-support payments -- so your divorce documents should clearly delineate alimony from child support, if any.
To deduct alimony payments, you must enter on your tax return the Social Security number of the former spouse who received them. This former spouse will owe tax on the alimony income.
ESTATE PLANNING
Making unwise gifts. In 2007, each individual can give away up to $12,000 worth of assets to any number of recipients without owing any gift tax. (For married couples, the amount that can be given away is $24,000 per recipient.) For affluent people, this can be valuable for reducing future estate taxes.
Trap: In these days of long life expectancies and soaring long-term-care costs, too many advisers don't fully evaluate whether their clients might need this money for themselves down the line. Even worse, many advisers fail to set their clients straight on a common misconception -- that money given away is tax-deductible. It is not. It is merely tax-exempt for the recipient of the gift.
RETIREMENT ACCOUNTS
Naming the wrong IRA beneficiaries. How valuable your hard-earned IRA assets will be after your death is highly dependent on the beneficiaries you designate now. Many advisers don't make clear the extreme importance of naming beneficiaries properly.
Common mistake: Naming your estate as the beneficiary or failing to name a beneficiary at all. This can cost your heirs the benefit of extended tax deferral. The individuals who ultimately inherit the IRA assets will, by law, have to empty the tax-deferred accounts much more rapidly than might otherwise be the case.
Better: Name one or more individuals as beneficiaries. Individual beneficiaries can stretch out required distributions (and defer paying tax on those distributions) over either their own life expectancies or the former life expectancy of the deceased IRA owner, depending on the age of the IRA owner when he/she died.
Also important: Name contingent beneficiaries to allow your primary beneficiaries to decide whether to accept the inheritance or, if more appropriate, to let it go to another beneficiary with its tax benefits intact.
Bottom Line/Personal interviewed Edward Mendlowitz, CPA, partner in the CPA firm WithumSmith+Brown, 120 Albany St., New Brunswick, New Jersey 08901. He is author of The Adviser's Guide to Family Business Succession Planning (American Institute of Certified Public Accountants).
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