Year-Round Tax Planning Can Help You Avoid Costly Errors

The federal tax code is extremely complicated and difficult to understand. Each state (and the District of Columbia) with an income tax has its own tax code. These tax codes change most years and retroactive tax changes have become more frequent. The difficulty of the tax code makes year-round tax planning difficult.

I have been preparing U.S. income tax returns for 20 years. I have filed returns in at least 30 states and the District of Columbia. I have signed more than 7,000 federal income tax returns and a similar number of state income tax returns.

I enjoy researching the income tax code and preparing income tax returns. What breaks my heart is performing what I call a tax autopsy. This is when a client commits an unforced error and does something with major tax consequences that an accountant does not find out about for the first time until preparing the person's income taxes for the prior year.

For many Americans, and a strong majority of my clients, income taxes are the single highest expense they have over their life. Tax planning is minimizing the income taxes you owe over your lifetime in a legal and controlled fashion. It’s a year-round activity that is separate from completing and filing your annual income taxes. Proper tax planning eliminates surprises as well as underpayment penalties and interest.

Across the couple of tax autopsies I do every year, in each case, the taxpayers likely would have benefitted from discussing the matter with a professional to ensure they understood the tax ramifications of the event or events in question.

Tax autopsies often result in a large amount of income tax being owed, and the amount owed is often unexpected. This can cause stress and angst. It may also cause financial hardship. In some cases, it can cause underpayment penalties and interest. In the worst cases, liens and levies can be put into place by taxing agencies.

The key to avoiding tax autopsies is communication. The tax code is so complicated, and it changes so often, that few people have a strong understanding of how income taxes are calculated.

There are many different items taxpayers should discuss with professionals. Examples include retirement, which can create issues due to lack of withholding; retirement distributions; Roth conversions; selling a property with a taxable gain; bonuses; equity compensation; gains realized from the stock market or cryptocurrency; legal settlements in certain circumstances; or profits from one or more businesses. The list goes on and on.

One item that can create a serious tax autopsy for lower-income families is worth a longer discussion. Centers for Medicare & Medicaid Services is the federal agency that provides health coverage to more than 160 million people through Medicare, Medicaid, the Children's Health Insurance Program, and the Health Insurance Marketplace. Per CMS, in February 2024, 20.8 million people received health insurance through the Marketplace. In February 2024, 19.3 million Marketplace enrollees, or 93% of total marketplace enrollees, received Advanced Premium Tax Credits (APTC).

When enrollees sign up for Marketplace coverage, generally between November 1 and December 15 of the prior year, the enrollee must estimate income (otherwise known as Modified Adjusted Gross Income or MAGI) for the next calendar year. This is extremely challenging. For example, people signing up today are estimating their 2025 MAGI and their actual 2025 MAGI will not be known until the 2025 income tax returns are filed in 2026.

The federal government directly pays a portion of the monthly premium for the 93% of enrollees who choose to get the advanced subsidies based on the enrollees MAGI estimate. When the enrollee’s income tax returns are filed, their actual MAGI is calculated, and the subsidy is reconciled on the Form 1040. You can change your estimated income throughout the year through the Marketplace.

If the enrollee's MAGI is less than the estimated amount given to the Marketplace, life is good. The taxpayer then was not paid enough APTC, and they will get credit for this underpayment on the Form 1040. The worst case is when a taxpayer's MAGI is higher than the estimated amount they provided to the Marketplace. This means the enrollee received too much money in subsidies and this amount is added to that person's federal tax liability in most cases.

In this situation, the tax autopsy happens when the enrollee has more taxable income than previously estimated. This can happen for a wide variety of reasons. Beyond what was mentioned earlier, the one I see most often in this circumstance, is taxable retirement distributions. The amount of money that must be repaid depends on the exact circumstances; however, I have seen quite a few taxpayers have to repay several thousand dollars in subsidies they were not due. This is difficult because taxpayers that receive health care subsidies are low-income taxpayers.

Year-round tax planning can help prevent tax autopsies and save taxpayers a significant amount of their hard-earned money.

By Mike Sylvester, Contributor