by John | Feb 20, 2017 | Tax Strategies, Wealth Protection
I’ve written about how I hate tax refunds.
I want to share three ways I avoid getting one.
I’m not a tax advisor, CPA, or attorney. I’m just sharing what I’ve done in the past as an individual subject to United States taxes.
This isn’t tax advice.
In my experience there are two steps to avoiding a tax refund.
Step one is to have an accurate prediction of how much tax I will owe (or get refunded) at the end of the year and (this is the key) knowing this information before the calendar year ends when I can still do something about it.
The second step is to take action to influence how much tax will be owed at the end of the year. All while being careful not to owe too much.
It’s important to know the maximum one is allowed to owe in federal taxes and the state level as it could change.
In past years it was $1,000 at the federal level. If one were to owe more than $1,000 in taxes there would be penalties.
Step One: Know How Much Tax you will Owe (or be Refunded) in Advance
Most people don’t look at their taxes until the next year.
For example, right now, most people probably haven’t even looked at their 2016 taxes yet. When they do and they realize they will be getting a $2,000 tax refund, well there is nothing they can do now, except file their taxes as soon as possible to get the refund check.
But if one were to assess his or her tax situation in June of 2016, there would still be half a year to make changes.
So how do I predict how much tax will be owed at the end of the year?
There are several ways.
Use Last Year as a Proxy
At a very basic level, one could use the past year as a proxy.
Ask yourself, did I get an income tax refund last year? If so, ask, am I going to be making the same amount next year? Will I have the same or similar capital gain/loss. Will I be making similar charitable contributions?
If one’s tax situation last year is likely to be very close to what it will be this year then it makes sense there will be a similar tax refund.
This isn’t a very sophisticated approach but it is a start.
In order to make an accurate prediction of how much income tax will be owed more a more detailed and comprehensive approach is needed.
Use Income Tax Calculators
Last year I put together a complicated spreadsheet that basically enabled me to calculate my income taxes during the year.
But rather than reinvent the wheel manually like I did–it would have been better to use the prebuilt tools and resources available to calculate taxes due.
One could experiment with the TurboTax W4 Calculator. Armed only with a copy of the most recent pay stub, as well as some other information, like charitable contributions, capital gains/losses, one can tweek allowances to avoid getting a refund.
Turbotax also has something called Taxcaster.
I wish I had known about these last year.
They key is having tools available to predict how much tax one will owe (or have overpaid) during the current tax year, while a person can still make changes.
Another strategy I’ve used is to start my taxes in December. By December 2016 I had filled out most of my tax information in Turbotax.
Sure, I didn’t have 1099s, W2s or many other tax documents, but I can look at pay stubs to figure out how much my W2 will be, I can look at my brokerage statements to see gains and losses.
This allows me to make decisions when I can still influence my 2016 taxes.
Step 2: Take Steps to Avoid a Tax Refund
Once I have a good prediction of how much of a tax refund I’ll get based on income, charitable giving, capital gains, and other tax situations it’s time to do something about it.
Strategy One: Increase Allowances on the W-4 Worksheet
Increasing allowances on a W-4 reduces the amount of tax withheld from each paycheck.
The tools referenced above enable one to tweek withholding allowances to make sure some money will be owed at the end of the year.
If the max I’m allowed to owe at the end of the year was $1,000, I would try to owe around $500 or so.
This provides some wiggle-room, because despite best efforts, the tax situation could change and I’m only able to estimate what I think my taxes will be Maybe I’ll decide to give a big $1,000 check to the charity in December, or maybe I’ll suffer a large realized stock loss I wasn’t anticipating.
These are things that a taxpayer might not realize are going to happen until later in the year.
Strategy Two: Convert IRA Money to a Roth IRA
I think taxes will be higher in the future than they are now.
So when it comes to retirement accounts I prefer paying taxes upfront (when I think they’ll be lower) and then having that money grow tax free over the course of 40-50 years, and then be able to withdraw it tax free.
Thus I prefer a Roth IRA over a traditional IRA (and Roth 401ks over 401ks).
But employer’s tend to do company matching to a 401k which is pre-tax money. I’ve been in several jobs that had a 401k and upon leaving those employers I’ve rolled my 401k money into an IRA.
So if I know I’ve overpaid my taxes I will convert some of my IRA money to a Roth in late December.
This increases taxable income, but one can opt NOT to have taxes withheld during the conversion.
This tax is still owed of course, but the payment can be delayed until later in April.
So if I know I’ll be getting a refund I can use that as an opportunity to convert some of my IRA money to a Roth.
I did this last year. I was working a W2 job for a half a year, and then when my contract was up I had no job. So I’d been overpaying withholding taxes.
So I decided to convert a large portion of IRA funds to a Roth IRA to avoid getting a refund. If I had known I was only going to be working for half a year I would have increased my withholding allowances.
Strategy Three: Realize Some Capital Gains
You want to be smart about this.
I wouldn’t sell a winning investment just to avoid a tax refund, but if you’ve been thinking about getting out of a winning position anyway, doing so will increase your taxable income.
In the US short term gains are currently taxed as ordinary income.
Strategy Four: Give Money to Charity
This strategy doesn’t help avoid a tax refund, but it is invaluable if you have underpaid your taxes too much, because it is a way to avoid penalties (see page 51).
If I realize that I owe more than the penalty-free amount on my taxes, I’ll give some money to charity or make some additional donations or put some money in a Health Savings Account.
These contributions reduce taxable income and can be useful when avoiding penalties that can be assessed if too much tax is owed at the end of the year.
Similar to strategy one, you can also reduce your withholding allowances to have more tax withheld each paycheck, if you realize that you’ll wind up owing too much at the end of the year.
I Hate Tax Refunds
I hate tax refunds because they are an interest free loan to the government and I have better use for my hard earned money than the IRS does.
It’s vitally important to legally pay all taxes due and remain in compliance with all applicable tax laws. It’s just not worth trying to cheat the IRS.
But there are legal ways to reduce your taxable income and avoid getting a tax refund.
Avoiding a tax refund has nothing to do with cheating the IRS or evading taxes.
It’s simply a way to make sure you aren’t paying more than you’re legally required.
It’s also a way to make sure that you don’t pay the taxes you owe earlier than you’re legally required to do so.
The above strategies are merely things I’ve done in the past to manage my tax burden and isn’t advice.
But these ideas could spark some conversation when you speak to your licensed tax advisor and as you make your own tax decisions based on your own unique situation.
by John | Jul 24, 2016 | Tax Strategies, Wealth Protection
Five Tax Strategies I use to Keep More of My Hard Earned Income
You work hard for your money and you deserve to keep it! Today I share five US tax strategies that allow me to keep more of what I’ve earned.
I don’t know if these tax strategies are suitable for you. You need to make your own decisions with the input and advice from a licensed tax professional and investment advisor.
I have a Master’s Degree in Human Resources and have studied employee benefits but I’m not a CPA or tax advisor. What I’ve written below is accurate and lawful to the best of my knowledge as of posting this article but I can’t guarantee that my understanding of the tax code is complete, accurate or up to date. Tax laws do change and in the future the below information could become outdated and/or incorrect.
I’m sharing what has worked for me!
Tax Strategy 1: Contribute to a 401k
A traditional 401k allows you to save money for retirement using pre-tax dollars. Your contributions are exempt from state and federal income tax. You do still have to pay social security and medicare taxes on 401k contributions.
Trivia: a 401(k) plan is the tax-qualified, defined-contribution pension account defined in subsection 401(k) of the IRS code.
When you retire and are eligible to make 401k withdrawals you do pay taxes on your withdrawals but your money will have (hopefully!) grown and if you’re retired you might be in a lower tax bracket then when you were working.
If my employer offers a 401k plan with company matching I contribute as much as I can to get the full company match but no more. That’s because the investment choices most companies offer are very limited. I do max out the company match so I’m not leaving money on the table.
I go with a Roth 401k if my employer offers it but they’re less common. With a Roth 401k you pay taxes up front but when you withdraw the money in retirement that income is tax free. I think taxes in the US are going to go up so I think it’s better to pay taxes now at the lower rates and get tax free retirement income later.
If your tax rate is the same during retirement as when you contribute to the 401k there is no advantage between a Roth 401k and 401k.
Two of my employers have offered Roth 401ks and company matching. When I left those employers, I rolled my Roth 401k into a Roth IRA and any 401k contributions into an IRA.
Tax Strategy 2: Contribute to an Individual Retirement Account (IRA)
The Roth IRA is one of my favorite tax strategies. Like 401k’s you get to pick your “flavor” of IRA: Roth or traditional. I favor Roth IRAs for the same reason I favor Roth 401k’s: because I believe tax rates will be going up in the future. Whether your employer offers a 401k or not you can open up an Individual Retirement Account (IRA) on your own.
To open a Roth IRA you just need some money and a custodian like Vanguard or TD Ameritrade. Once I’ve maxed out my employer matches for my 401k (if offered) I contribute additional retirement savings to my Roth IRA.
Through Vanguard I’m able to invest in many more securities and mutual funds than any employer offered investment options I’ve seen.
With a Roth IRA I will be able to enjoy tax free income during retirement, and it grows tax free while I wait. I’ve had a Roth IRA since I was 16 and it has been a great way to save for retirement.
If I gave investment advice I would implore everyone with $1,000 they could afford to set aside to open a Roth IRA today. I posit it is the most powerful of all five of these tax strategies.
Tax Strategy 3: Contribute to a Flexible Spending Account (FSA)
This is my second favorite of the five tax strategies. Your employer might offer a Flexible Spending Account. All of my employers have. Like a 401k, you use pre-tax dollars to set aside money for eligible medical expenses like doctor visits and prescription drugs.
In addition to the tax benefits are three nice perks to an FSA.
1) You can spend the money right away as long as it is an eligible medical expense
2) Not only do you not pay state or federal income tax on FSA contributions, but you don’t pay social security or medicare taxes either
3) If you stay at the company but don’t spend all the contributions you’ve made they roll over to the next year
One NOT so nice feature of the FSA is that if you leave your employer you lose it. You can’t take it with you.
But one crazy loophole that an HR representative once told me about was that you can spend all the FSA contributions you would have made for the year, even if you leave the company.
For example, lets say you’re set to contribute $20 per month to your FSA. That is $240 per year. Lets also say the company’s fiscal year starts on January 1 and you get paid on the first of each month. If you enroll in the FSA program and are set to contribute $20 per month, and you leave your employer at the end of March, before your last day of employment you can spend up to $240 on eligible expenses using your FSA, even though you’ve only contributed $60. Crazy!
If you have recurring medical expenses like prescription drugs, dental cleanings, doctor visits or eye exams an FSA is a no brainer if your employer offers one. Some employers will even match FSA contributions.
I’ve had an FSA at my last three employers and it’s a great way to save on medical expenses.
Tax Strategy 4: Contribute to a Health Savings Account (HSA)
Not everyone qualifies for an HSA. The IRS tells us you’re eligible to open an HSA if you meet the following:
- You must be covered under a high deductible health plan (HDHP)
- You have no other health coverage except what is permitted under “Other health coverage”
- You are not enrolled in Medicare
Plans with the following deductibles qualify as High deductible Health plans:
- Self-only coverage minimum annual deductible $1,300 / Maximum annual deductible and other out-of-pocket expenses* $6,450
- Family coverage minimum annual deductible $2,600 / Maximum annual deductible and other out-of-pocket expenses* $12,900
Having recently gained the status of unemployed and having bought a high deductible healthcare plan, I opened up an HSA through a company called Select Account. My very good friend who is self employed recommended them to me. Assuming I remain eligible for the HSA, I should be able to deduct my HSA contributions on my taxes.
I like HSAs because unlike FSAs they stay with you. What I don’t like about them is that you can’t invest the HSA contributions, so you’re stuck in depreciating dollars. The IRS is also very particular about who qualifies for an HSA, so when I start my next job, and that job offers health insurance, I might lose my eligibility for the HSA.
If you want to torture yourself you can read more about HSAs over at the IRS website.
Tax Strategy 5: Stop Getting a Tax Refund!
I don’t understand why people get excited about tax refunds. A tax refund means you overpaid on your taxes, you haven’t had that extra money all year and now the government is giving your money back to you that you loaned to them interest free.
I calculate/estimate what my taxes are going to be and then tweak the allowances and deductions on the W-4 worksheet so that I will owe about $900 in federal taxes at the end of the year.
Depending on the state you can do something similar for state income taxes.
By owing a small amount of money to the IRS on April 15 I’ve essentially got the refund through the year in the form of slightly higher paychecks. I’ve also held onto my hard earned money for as long as possible.
You do have to be careful with this because if you underpay by over $1,000 on your Federal taxes you get penalized. States that allow this will probably also penalize you if you underpay by too much, I know Illinois does.
Again I’m no CPA so consult a competent tax advisor before you try something like this. You can read more about the underpayment penalty over at the IRS website.
What do you think of these Five Tax Strategies?
These are five tax strategies I use to keep more of my hard earned income. I will say if you don’t have a Roth IRA you’d better have a darn good reason.
Do your own research, determine what is suitable for your situation and ask your tax advisor if one or more of these strategies is right for you.
If you’re interested in saving more money from the “inflation tax” consider keeping a portion of your savings in gold.