Join me in an interview with Curtis Smith CFP®, a fee-only Financial Advisor,
to find out how a Roth IRA works and if it is right for you.
You can listen in at
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7. Tax Planning
Many people don’t bother reviewing their federal tax return after it has been prepared. That’s a big mistake. As a Financial Advisor, I always insisted on reviewing the federal income tax forms with the client. I can find out a lot about the accounts and the investments of a person through a review of these forms. There are many valuable insights that you can get from an income tax review that can build wealth and help with financial decisions during the year. Here are just a few:
- When you get your refund or a statement of what you owe, many people mistakenly think that amount is what they paid in tax. That is not true. Go to line 61 of the Federal Form 1040 and see what you paid in tax. If that is a high percentage of line 22 which is your total taxable income, then that is a sign you may need more tax deductions.
- Line 8a Taxable interest and 9a Ordinary dividends are the earnings that you are paying tax on. Those earnings usually come from bank saving accounts and money market accounts. If this is a high amount, then it may be time to look at putting some of that money into a long term growth investment like a mutual fund.
- Line 13 and 14 are capital gains from your investments. If this number is high, then I would look into the investments you have that are creating such high amounts of capital gains. It may also mean that you sold some investments that had a gain and I would want to know why.
- Line 15a and 16a have to do with distributions from your retirement plans. If a rollover was done properly, it should show 0. If it wasn’t, I would ask what happened and see if that can be reversed. Believe it or not, I have had this happen. Also, I make sure that IRA distributions weren’t taken out before age 59 ½ because then a penalty would show on Line 58. I would advise the client to look for other ways to get income other than paying income tax and penalty tax on an IRA distribution.
- Line 20b is the dreaded taxable amount of your social security. Yes, social security is non-taxable but only to those who have income under a certain amount otherwise there is a pro-rata tax on your social security.
- Anything entered on Lines 23-37 would tell me if the client had deductions against their income. The most popular is line 33 which is student loan interest deduction. If that was a high amount, I would work with the client to get their student loans modified or get the interest lowered.
- Line 40 is the total of your itemized deductions. Most people who have a loan against their home will have an entry here because of the mortgage interest expense. A tell tale sign that a client should look into buying a home is when the total tax amount is a high percentage of the total income amount.
- Compare Line 7, total wages with Line 61, total tax. If I see that the client is paying too much in tax compared to their wages, I will ask if they are maximizing their 401K, or 403b, or other deferred compensation plans. Usually I get a no. If they would maximize their retirement plans they would pay less in tax and more towards their retirement security.
- Line 62 is the total tax withheld from your paycheck. If it wasn’t enough to pay the tax on line 61, then you didn’t have enough withheld. But don’t panic! That’s a good thing. It’s okay to have to pay some tax at the end of the year (but not a large amount that would trigger a penalty). In fact, that’s ideal. That means that you got a higher amount in your paycheck than someone who got a huge refund. Those that get a huge refund are giving the government an interest free loan with their money. Some people who are not financially disciplined use this technique as a forced savings account so they can spend it on a car or vacation. You, however, are the smarty pants that took the extra money each month and invested it and got even more money so now you have to pay a little bit of tax. It was well worth it since you came out ahead.
As you can see an income tax review is a great way to build wealth. I consider the federal tax return a snapshot of a person’s whole financial picture. You can use the federal income tax forms as a guide to answer questions such as whether to contribute more to deferred compensation plans, buy a home, or change your investments, and more.
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Just 17 more days left to save money on taxes-
do some of these easy tax saving tips for cash in your pocket in new year
(Note: I personally have done 3 of these and expect an extra $1,000 in my tax refund in April -WOO-HOO!)
Top 7 Year End Tax Saving Tips
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Lowering your tax liability is one of the fastest ways to increase cash flow and build wealth. I was making a long post about all the legal deductions that you are allowed to take and that most people miss on their tax return. Then I threw it away. There are lots of articles and resources on the internet that can give you that information and more.
If you don’t have a face to face meeting with your tax preparer then you should be using some kind of software to make sure that you are taking all the deductions that you are legally allowed to. This is a fast way to increase your cash flow and well worth your time.
What I really want to point out is that are many tax credits that people miss out on because they assume that their income is too high and they don’t qualify, and so they miss out. A tax credit is a dollar for dollar reduction of your tax. Here are just a few of the most common tax credits:
Retirement Saver’s
Making Work Pay
Education-Lifetime Learning
Education- American Opportunity
Earned Income
Child and Dependent Care
First Time Homebuyer
Alternative Motor Vehicle
Health Coverage
Elderly or Disabled
Many people fail to tell their tax preparer of these things that could help them qualify for the credits. Here are some examples:
“I bought a hybrid car this year”
“I got laid off and am taking courses to improve my job skills”
“I am paying for my son’s college expenses”
“We bought our first home this year”
“We had high child care expenses”
“I made retirement plan contributions this year”
Let’s take an example of the retirement saver’s credit. This is a non-refundable credit is for individual ($1,000) or married filing joint ($2,000) for eligible contributions to an IRA or an employer sponsored retirement plan (401K, 403b). The credit is phased out to 0 if your adjusted gross income is over $55,001 (married filing joint) or $27,751 (single). With so many people having spouses out of work, many people qualify and don’t know about this.
Remember a credit is not like a deduction. A tax credit is cash in your pocket now. A tax deduction lowers your overall income so your tax is lessened.
Make sure your tax preparer knows your situation. Fill out the tax organizer thoroughly. If you use software, make sure you answer all the questions about your household. Don’t leave money on the table because you didn’t have time to properly fill out the forms. To build wealth we make our money work for us so we can have a secure financial future.
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I have met lots of folks who believe that to build wealth they need to make a big salary- then it’s all good. Well, wake up, because it ain’t . Inflation and taxes are lurking and munching down on that salary each year so your whole net worth (meaning what you own) has to be going up to keep up. Some reasons it won’t:
You continue to spend more than you take in
You continue to pay interest only on your mortgage
You continue to not participate in deferred compensation plans
You continue to “play” the stock market and never make any real after tax after expenses profit.
You continue to plan vacations instead of planning to stop work or work part-time
You continue to support family members to the demise of your retirement plan or your children’s education.
You continue to borrow for cars, boats, etc. that depreciate in value.
Your net worth which is everything you own minus your debt is what matters. If you have no clue as to where the money is going –do this little exercise to find out. It isn’t super accurate but it will give you an idea of where the money is going.
Look at your form 1040 Line 7 –that is the amount of income that you earned for the year. Now subtract the number from line 61 which is the amount of tax withheld. That is the net amount that you lived on and then divide by 12 for the monthly amount that came into your household.
Now take the amount that you saved during the year and divide that by the net amount that you lived on for a percentage of the amount saved. That percentage should be 10-25%. If it is a negative then you are spending more than you are taking in and your net worth will go down.
Okay now for the positive. Keeping track of spending actually helps you build wealth but also grows how happy you are. When we track our spending and then spend it, we can develop a habit of gratitude (thankful for be able to take the family on a cruise) for what we have and also for what we accomplished (saving for a vacation or a child’s education). New studies are coming out that show being grateful forces people to overcome what psychologists call the negativity bias – the innate tendency to dwell on problems, annoyances, and injustices rather than upbeat events. Focusing on our blessings can help ward off depression and build resilience in times of stress, grief or disasters.
So as you take this journey to build wealth, take action to increase your net worth and consider what you have and be grateful for it.
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Saving money on taxes is an easy step to build wealth
immediately. You must be aware of tax law changes though in order to take action on opportunities that arise. Last minute legislation was passed to extend the Bush-Era tax cuts for a short period of time. The new law is called the Tax Relief, Unemployment Insurance Re-authorization and Job Creation Act of 2010. I have been studying this extensive legislation and thought I would pass on some highlights below of the law that will affect most of you:
- Two year extension of the tax rates
- Two year extension of the dividend and capital gain dividends reduced tax rates (0 or 15%)
- Two year repeal of the personal exception and itemized deduction phase out
- 35% top estate, gift tax, and generation skipping tax (GST) rates and $5 million exemption
- Exemption amount will be indexed for inflation starting in 2012
- For 2010, the AMT (Alternative Minimum Tax) exemption amounts will be increased and non-refundable personal credits can be used against AMT.
- You can still use up to $100,000 tax free distributions from your IRA for charitable contributions
- Deduction of state and local sales taxes
- 30% tax credits for energy efficient improvements to the home
- Expansion of Coverdell accounts and definition of education expenses
- American Opportunity Tax Credit for tuition expenses of up to $2500
Some legislation that wasn’t extended:
- 100% of unemployment benefits are taxable now
- The Energy tax credit is extended to 2011 but is now limited to a lifetime cap of $500 for purchases between 2006 and 2011
- Required Minimum Distributions are required and fully taxable
- The First Time Homebuyers Tax Credit was not extended but military personnel may qualify for a one-year extension through mid 2011
- The Build America Bonds program which was very popular will not be renewed in 2011
You can find more information at the Internal Revenue Service site. By being conscious of tax laws that affect you and your financial situation, you can save loads on your taxes and put cash flow into your pocket immediately. Make it a habit to review your tax situation once a year to build wealth effortlessly.
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Tax planning consists of the use of tax deferrals, tax deductions and tax credits to legally reduce your tax liability. The one that most of you are familiar with is tax deferral. That is because most of you have a 401K plan at work.
For example, if you earn $100,000 a year and contribute $10,000 to a 401(k) plan, you’ll pay income taxes on $90,000 instead of $100,000 so you saved taxes on $10,000 of income. Woohoo!!!
Most of you also get a “matching contribution” from your employers. For example, you earn $30,000 a year and work for an employer that has a matching 401(k) plan. The match is half of every dollar up to 6 percent of your salary. Each year, you contribute 6 percent of your salary ($1,800) to the plan and receive a matching contribution of $900 from your employer. That’s an automatic, no risk return of 50% on your investment! Woohoo! Yet a recent study found that, among employees younger than 59 ½, 54% did not take full advantage of the company match!
Now the downside – okay, so you can’t take the money out until you are 59 ½ years old or there are severe penalties – like a 10% federal penalty and 2.5% state penalty (if you live in CA) plus federal and state income taxes on the amount withdrawn. A cash withdrawal on a credit card is cheaper than this. But that is why they call it a retirement plan, folks. It really is for when you retire.
Let’s talk about the deferral part. If you could save $15,000 a year for 30 years in your 401K and let’s assume you only got a 5% return annually on your investment, you would have accumulated $67,016. But if you had it in a taxable account (assuming a 25% federal and 6.8% state tax rate), you would have accumulated only $41,662. Big difference! Taxes do eat into your return.
President Bush signed the Pension Protection Act of 2006 into law on August 17. The PPA contains many changes for defined contribution plans (401K, IRA, Roth IRA, SEP-IRA, etc). See your Financial Advisor to make sure that you are taking advantage of these changes.
Sign up for the maximum contribution to your 401K plan at work now. You won’t miss the money. For a specific calculator to see how much you would save with your 401K, check this out: Individual 401(k) Savings Calculator
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File your taxes late? Yes, some tax rules are made to be broken. The rule I am talking about is filing your taxes by April 15th. Some people can prosper by not filing timely. Here is #3 of 3 of those situations:
2. Multiple Roth IRA Conversions
3. Home buyers who haven’t completed their purchases but plan to take one of the two federal tax credits that they qualify for -one for first time buyers and the other for repeat buyers.
All taxpayers qualify for an automatic 6 month extension (From 4868) but it is not an extension of payment. If you owe tax and don’t pay it, the current rate of interest (4%) will be charged from April 15th till paid.
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File your taxes late? Yes, some tax rules are made to be broken. The rule I am talking about is filing your taxes by April 15th. Some people can prosper by not filing timely. Here is #2 of 3 of those situations:
2. Many taxpayers are setting up multiple Roth Conversion accounts in early January with a separate account for each asset class, and then waiting the maximum 22 months (until October 15th of the following year) to see which assets have prospered and which haven’t. They plan to undo the conversions for each account that declines in value (called a re characterization) after conversion so that they don’t have to pay tax on the higher value.
3. Homebuyers
All taxpayers qualify for an automatic 6 month extension (From 4868) but it is not an extension of payment. If you owe tax and don’t pay it, the current rate of interest (4%) will be charged from April 15th till paid.
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File your taxes late? Yes, some tax rules are made to be broken. The rule I am talking about is filing your taxes by April 15th. Some people can prosper by not filing timely. Here is #1 of 3 of those situations:
1. If you are making a Roth IRA conversion, filing an extension can juice returns. The rules allow taxpayers to reverse their conversion until October 15th, either with an extension or an amended return.
All taxpayers qualify for an automatic 6 month extension (From 4868) but it is not an extension of payment. If you owe tax and don’t pay it, the current rate of interest (4%) will be charged from April 15th till paid.
2. Multiple Roth IRA Conversions
3. Homebuyers
Since many of us use tax software or have tax preparers that use tax software programs, I cannot emphasize enough the importance of reviewing your return in detail. Many tax software programs have bugs that calculate passive gains and losses, AMT, and and other items incorrectly. I know because my spouse found a glitch that our CPA missed that was caused by software error (Thanks, Honey!). So take the time to review the finished return before mailing.
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