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What you can — and can't — learn from a tax return

Tax returns don't really show much. That's been President-elect Donald Trump's story since the beginning of his run for the presidency and he is still sticking to it. "You learn very little from tax returns," said Trump, in response to reporter questions at his first post-election press conference Jan. 11.

There's no question that this ongoing assertion by Trump about the unimportance of tax returns has gotten, and held, the attention of many accountants and financial advisors who've long presumed the opposite — regardless of whether they lean red or blue.

Therefore, I thought it might be helpful to combine my experience with that of a few close colleagues in search of an answer to the objective, nonpolitical question: What exactly can — and can't — you learn about a person from his or her tax return?

A comprehensive review would be enough to put anyone to sleep, so we narrowed it down to four categories of information likely the most applicable to the majority of taxpayers: what people earn in income, what they own, what they save and what they give.

Donald Trump
Mike Segar | Reuters
Donald Trump

1. What people earn. We do learn just about everything there is to know about the incomes of most people who generate income solely on a W-2 from their employer. Any additional sources of income could come from taxable investments that generate interest, dividends and capital gains, although the story becomes cloudier due to their variability.

For the self-employed, the picture becomes hazier yet. While we may see their taxable income from business interests flow through to the tax return, we don't learn as much about income erased by deductions. This is because a business owner may benefit from the use of automobiles, travel, entertainment, technology, education and other "perks" that certainly enhance one's lifestyle but may also be considered legitimate deductible business expenses.

You can gain some clarity by reviewing a sole proprietor's Schedule C and various other worksheets floating in the background of a tax return, but we still learn less about earnings from a self-employed person's tax return than we would from the tax return of a more typical employee. And the more businesses a person owns or is part of, the further their income picture could arguably be obscured.

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2. What people own. We do learn something about the assets people own through a tax return, but this education pales in comparison to the one other accounting document — a simple balance sheet — because assets only show up in a tax return indirectly.

For example, we may learn that someone has an inherited individual retirement account because they received a required minimum distribution from it. We may learn that someone has (or had) a stock position if they realized capital gains, or that they lost a great deal if the loss carried forward offsets capital gains or ordinary income.

We learn something about a person's asset location — if they warehouse their stocks in taxable accounts (a generally good idea, as stocks receive favorable tax treatment relative to bonds in taxable accounts). But we don't learn much at all about their portfolio asset allocation, especially because a tax return doesn't tell us anything about what's inside of a retirement account.

We may be given an indication of the degree to which someone is actively or passively invested, because an active strategy employed in a taxable account will likely be indicated by various 1099s. But we learn almost nothing about the total value of bank, brokerage and retirement accounts.

Archive Photos | Getty Images

3. What people save. Here is where we do learn a great deal about how much people save and in what types of vehicles. We should learn exactly what amount someone has saved in a 401(k) or other corporate retirement plan, as well as in a traditional IRA or Roth IRA. But we don't learn much about income pledged to taxable savings vehicles and brokerage accounts.

4. What people give. We do learn a lot about some types of giving, but nothing about others. As long as someone itemizes deductions on their tax return, we should know precisely what they have given in cash gifts (with receipts) to nonprofits. We can even learn what folks have given in noncash gifts, such as bags of clothes or well-used furniture.

We don't learn, however, about charitable acts that involved pro bono or discounted business services — or even acts of individual service, such as donating time to a local soup kitchen (although you may be able to deduct the travel expense).

That being said, I do believe that a tax return reflects a reasonable picture of one's charitable nature, because when we are truly passionate about a cause, we tend to be involved both physically and financially.

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It has been said that reviewing someone's calendar and checkbook (or, these days, credit card statement) will tell you a lot about what's important to them. I do believe that we can add their tax return to that list. Especially for those who know what to look for, this document can provide a very quick impression of someone's financial situation and, perhaps, even a window into their values and their goals, the foundation of every good financial plan.

Or as my colleague, Ken Rosenbaum, a certified public accountant, put it: "You can't sketch a person's face from looking at their tax return. But maybe a caricature."

— By Tim Maurer, director of personal finance for Buckingham and The BAM Alliance (Author's note: Special thanks to my colleagues Larry Swedroe, Ernest Clark and Ken Rosenbaum for their contributions to this article.)