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.