Americans begrudgingly participate in tax season every spring. We round up our W-2s, 1099s, and K-1s while frantically searching for deductions. We swap emails with our accountants about life changes and eventually determine how much we owe (or are owed). This beast of a chore is a burden we all must endure to stay in compliance and avoid jail.
However, tax preparation is more than an exercise in compliance. It is a potential goldmine of financial planning insight – from critical clues about the quality of your financial advice, to insights into long-term tax strategy. Remember the adage that what matters is not what you make, but what you keep—not just today, but over your lifetime and across generations of heirs who will inherit your financial legacy.
Let’s explore how a strategic review of your tax return can uncover financial planning opportunities and potentially reveal whether your advisor truly serves your best interests.
1. Using Your Tax Rate for Strategic Planning
Tax Rate Opportunity Assessment
Before rendering financial advice, one of the first things a good advisor will assess is your tax rate. An average tax rate below 25% suggests that accelerating your income might be warranted. Accelerating income can mean making tax decisions that result in paying taxes now rather than later.
Many investors focus too heavily on reducing today’s tax bill, without realizing that this could result in much larger future tax bills. Sophisticated planning sometimes involves strategically increasing certain taxes today to (sometimes significantly) reduce your lifetime tax burden.
This can be accomplished by:
- Making Roth contributions (instead of pre-tax) inside qualified plans at work.
With this strategy, you pay taxes on contributions now, and then those assets grow tax-free and remain tax-free upon withdrawal in the future, even for beneficiaries. - Converting Traditional IRA assets to Roth.
In this case, you will owe taxes on the pre-tax portion of the converted IRA assets, but those assets will grow tax-free and be tax-free upon future withdrawal.
How to Calculate Your Average Tax Rate
Form 1040: Lines 24 and 9
Use the figures on your most recent tax return (Form 1040) to calculate your *average tax rate using the following formula.
Average Tax Rate = Line 24 (Total Tax) ÷ Line 9 (Total Income)
This calculation reveals the percentage of total income paid in federal taxes. As opposed to the marginal tax rate, your average tax rate provides a clearer picture of your overall tax burden relative to gross income. It serves as a baseline for evaluating tax planning opportunities.
Let’s look at a simple example using 2025 numbers from the tax bracket chart below:
A single wage earner (with no other sources of income) has taxable income of $250,526 (Line 15 on your 1040). That puts them in the 35% marginal bracket (by $1). They would owe $57,231 + 35% of any amount exceeding $250,525. That would result in a total tax (line 24) of $57,231.35.
Their total income is $265,526 (taxable income is reduced using the 2025 standard deduction of $15,000), so their average tax rate is as follows.
$57,231.35 ÷ $265,526 = 21.55% Average Tax Rate
In this extreme example, the taxpayer is in the 35% marginal bracket but pays federal taxes at an average rate of only 21.55%. That presents an opportunity** to consider Roth strategies.
*Average tax rate is the total tax divided by the total income. In this case, total income is your income before subtracting any above-the-line deductions from Schedule 1. That differs from the effective tax rate often included on reports from tax professionals, which they calculate by dividing your total tax by your taxable income after deductions (Line 24 ÷ Line 15).
**This example does not account for state or municipal taxes, which can significantly increase your average tax rate. Please consult your tax professional for advice before taking action.
2. The Capital Gains Clues
Form 1040, Line 7 and Schedule D: Capital Gains Revelations
If there is a positive figure on Form 1040, Line 7, that means you sold something for a gain. Look into what you sold and why. Validate there was a financial planning reason for realizing the gain (i.e., you needed money from an investment account, sold a business or a home, etc.). If there wasn’t a planning need, that could be evidence that your investments are not being managed tax-efficiently.
You may have large distributions or capital gains from investment products such as mutual funds or another active investment management strategy that is realizing gains. Look beyond your monthly statement to calculate if your after-tax returns justify the taxes you are incurring on these investments. Active management, where managers aim to outperform the market by selecting investments through research and analysis, is expensive to administer and comes with high costs to you, including both expense ratios and taxes.
Schedule D provides more details:
- Line 7: Short-term gains (taxed at ordinary income rates up to 37%)
- Line 15: Long-term gains (taxed at preferential rates of 0%, 15%, or 20%)
High short-term gains may indicate excessive trading—a strategy research consistently shows underperforms the market while generating higher tax bills.
3. Equity Compensation: Restricted Stock Units (RSUs)
Form 1040 Schedule D, Column E: Cost Basis and Form W-2 Box 14: Other Income
If you sold Restricted Stock Units (RSUs) in the past tax year, double-check that you did not pay more tax than you should have. When RSUs vest, you pay ordinary income taxes on their value, and that value becomes the cost basis for any shares you hold onto. If you sell shares later, you will owe capital gains tax on the amount over your cost basis (like a normal stock sale).
To check whether a mistake occurred, look at your income from stock compensation shown on Box 14 of your Form W-2. Check Schedule D, Column E of your 1040 to ensure that the cost basis of your sold units aligns with the reported value. We often see the cost basis of sold RSUs on Form 1040 incorrectly reported as “0,” causing tax-filers to pay capital gains tax on the full amount of the vested units in addition to the income tax they have already paid. Catching this mistake can potentially save you from paying unnecessary taxes.
4. HSA Strategy: The Triple Tax Advantage
Form 1040 Schedule 1, Line 13: HSA Contributions
If you’re eligible for an HSA and not maximizing contributions ($4,150 individual / $8,300 family for 2024, $4,300 individual / $8,550 family for 2025, plus $1,000 catch-up if 55+), you are missing out on triple tax advantages:
- Tax-deductible contributions
- Tax-free growth
- Tax-free withdrawals for qualified medical expenses
Unlike what many believe, HSA contributions do NOT have to occur through payroll. You can contribute directly from a bank account to your HSA at any time, until the following year’s tax filing deadline (typically April 15).
However, there’s a significant tax difference between contribution methods:
- Payroll Contributions: Exempt from federal income tax, most state income taxes, AND FICA taxes (Social Security and Medicare)
- Direct Contributions: Exempt from federal income tax and most state income taxes, but NOT exempt from FICA taxes
On a $4,150 individual contribution, payroll deduction saves about $317 more in taxes (7.65%) than direct contributions. So, while direct contributions are valuable, especially for prior-year catch-ups, payroll contributions maximize your tax savings*.
*A reduction in social security taxes paid may result in a lower social security benefit at full retirement age. Weigh the options carefully before making decisions.
5. Additional Insights Line by Line
Items 1 through 4 are typically the most significant opportunities, but the following could also be helpful depending on your situation.
Form 1040:
Line 12: Standard vs. Itemized Deductions
If you’re itemizing just slightly above the standard deduction, consider “bunching” deductions in alternate years. That might involve using a donor-advised fund, which enables you to fund multiple years of giving in a single tax year while distributing the gifts over time. Consider reading our blog titled “6 Charitable Giving Strategies” for the details.
Line 33: Tax Withholding and Estimated Payments Analysis
Compare your withholding (Line 25) to your actual tax liability (Line 24). A large refund means you effectively gave the government an interest-free loan, whereas a large payment due means potential penalties. Adjust your W-4 accordingly for better cash flow management.
If subject to estimated payments, look at Line 26 to see if you paid too much or too little. Use this figure to determine a plan for these payments going forward.
Clues from the W-2
You can also find some helpful tax data on the W-2 that you can’t find on Form 1040.
Retirement Contribution Strategies
W-2 Box 12, Code D or AA: Pre-tax or Post-Tax 401(k) Contributions
In box 12 of your W-2, you should see either code D (pre-tax 401k contributions) or code AA (post-tax Roth 401k contributions). There are two items to think about here:
- Did you maximize your 401(k) contributions ($23,000 for 2024, $23,500 for 2025, plus $7,500 catch-up if 50+, and $11,250 if 60-63)?
- Then, based on your tax rate analysis, consider whether you need to make an adjustment here. I.e., If your W2 shows code D (pre-tax) and your average tax rate is below 25%, consider shifting to code AA (post-tax Roth) instead.
W-2 Box 14: Additional After-tax Contributions
If your 401(k) plan allows after-tax contributions beyond the standard limits, you may be able to implement a “Mega Backdoor Roth” strategy. With this strategy, you can contribute up to the total annual limit ($69,000 for 2024, $70,000 for 2025, plus catch-up contributions if you are over 50, and super catch-up contributions if you are 60-63, minus employer contributions).
This strategy works best when:
- Your plan permits in-plan conversions of after-tax funds to Roth status, or
- Your plan allows in-service distributions of after-tax money that you can roll into a Roth IRA
For high earners who have maxed out traditional retirement options, this can result in tens of thousands of additional Roth dollars annually.
What High-Quality Advisors Should Be Doing
A truly comprehensive financial advisor should be working with you and your tax advisors by:
- Coordinating Tax and Investment Strategies: Understanding your average tax rate and ensuring investment decisions are considered on a net after-tax basis.
- Managing Income Timing: Helping you understand when to recognize income to manage tax brackets.
- Planning for Strategic Roth Conversions: Identifying opportunities to convert traditional retirement assets to a Roth during favorable tax years.
- Implementing Systematic Tax-Loss Harvesting: Proactively identifying opportunities to offset gains throughout the year.
- Optimizing Asset Location: Strategically placing tax-inefficient investments in tax-advantaged accounts and tax-efficient investments in taxable accounts
- Using Tax-Efficient Investment Vehicles: Favoring ETFs or direct indexing strategies over mutual funds in taxable accounts to minimize capital gains distributions.
Action Plan: What to Do With This Information
- Calculate Your Advisor’s True Cost: Add your advisory fees to any excess tax burden from investments. Use this information to evaluate the investment strategy’s effectiveness and the financial plan’s overall performance.
- Request a Tax-Efficiency Audit: Ask your advisor to explain the tax implications of their investment approach.
- Consider a Second Opinion: A truly comprehensive financial advisor should be able to demonstrate how their strategies minimize your tax burden while maximizing after-tax returns.
- Demand Tax-Coordinated Planning: Insist that any investment recommendation comes with a clear explanation of its tax implications. That typically requires coordination between your CPA and financial advisor.
Conclusion
Your tax return is more than just an annual compliance exercise—it’s a powerful financial planning tool that can reveal opportunities and potential problems with your current financial strategy. Understanding the story your tax return tells allows you to make more informed decisions about your investments, retirement contributions, and advisor relationships.
Remember, the best financial advisors don’t just manage investments. Through tax planning, they manage tax consequences for you and the legacy you leave. If your tax return reveals a disconnect between these two crucial elements, it may be time to reconsider your advisory relationship.
