Tax Return “Red Flag” Warning Signs

When is the last time you sat down with a CPA or tax advisor with your financial advisor to harvest and deduct against income or capital gains before year end.  Tax returns can be an important source of information.  A review of client tax returns is critical for the detection of warning signs for potential missed opportunities to better manage your investment accounts.  The following “red flag” warning signs should assist you in the determination of whether your investment accounts have been properly managed.

Substantial Account Losses: Substantial account losses, in percentage terms, may be a sign of the mismanagement of a client’s account, especially when a client has a limited ability to assume such losses.  The account performance relative to a suitable investment benchmark can determine the amount of damages.  The suitable investment benchmark is determined based upon an investor’s investment objectives, risk tolerance and investment time horizon.

Short-Term Holding Periods: A review of the holding periods for investments may indicate whether the transactions were for legitimate investment purposes or for the generation of additional commissions for the financial advisor.  The following are statistical measures of annualized account costs and turnover thresholds that industry experts believe reflect different levels of “churning”.  Schedule D provides information about portfolio turnover for non-qualified investment accounts.

Margin Interest Expense: The use of margin exposes a client’s portfolio to greater risk and expense.  Margin interest increases the investment return breakeven point for any investment strategy and is included in account costs when evaluating the cost ratios for “churning” or excessive trading.  According to academic studies, the use of margin to diversify a portfolio does not reduce the overall level of risk, therefore, the use of margin is questionable in most situations.  Margin interest deductions can be found on Schedules A and E.

Using Account for Checking & Credit Card Activity: It is dangerous for clients to use checks or credit cards offered through brokerage accounts.  Clients can lose track of spending discipline and brokers tend to over invest funds in non-cash securities resulting in the ultimate use of margin as a source of credit.  The itemization of personal expenses paid for through use of margin should be segregated from total margin balance to determine the deductible portion of margin interest.

Winners Sold Quickly, Losers Held: In some instances, a financial advisor will sell winning positions to book profits to gain client confidence to support continued trading activity.  It is also common for a financial advisor to hold losing stock positions too long before they are sold.  Without a disciplined, professional approach to investing by cutting investment losses and letting investment winners run, through the use of sell disciplines including, stop loss limit orders, client accounts can become mismanaged.  A review of the holding periods for the transactions reflected on the Schedule D should provide indication of this potential mishandling of a client’s account.

Securities Concentration: Concentration of your investments into securities of a single issuer, of a single asset category, or a single type of investment product is considered securities concentration.  The concentration of your invested assets in a single investment or investment strategy is not suitable because of the risks associated with any single strategy.  An asset allocation model determined by an investment policy statement is the prudent way to allocate investments across a diversification portfolio.

Switching (Mutual Fund and Variable Annuity): An investment in a mutual fund or variable annuity through sales proceeds from a another mutual fund family or variable annuity with similar features and investment options may be considered be a prohibited transaction,  according to the securities industry and state regulators, unless there is a true economic benefit.  If there is no economic benefit to the client and the reason for the recommendation was solely for the generation of commissions, the transaction is considered a “switch” transaction and is a violation of securities and insurance industry conduct rules.  On the 1040 Tax Return, line 15a (IRA distributions) and 16a Pensions and annuities) you can look at whether there are rollover transaction to review.

Personal Retirement Plans Funded with Insurance Products: Non-qualified retirement plans offered to key employees through businesses that are funded with insurance products are generally suitable.  The need for life insurance to indemnify a business from economic loss or recoup costs paid for promises to employees are valid business purposes.  However, policyholders are exposed to a risk of a taxable event, if an insurance policy lapses after years of withdrawals, when total policy withdrawals exceed the premiums paid.