I do not prepare tax returns, but as a financial planner, I understand taxes and can help my clients with their tax strategy. And it’s that time of year when many of you are about to freak out about your tax return.
Now is when all of those TV ads pop up, warning you that tax mistakes add up to billions of dollars; or the blog posts or articles going over all of the potential deductions, making you scared you’re going to miss something.
The truth is, most of your tax story was set in stone months ago, and there is very little you can do now to change things for your 2020 tax return.
The Tax Trade-Off
Most of the time, the tax deductions you get are from things you would have been doing anyway. For instance, you’re probably saving into a retirement plan, like a 401(k). You might save more if you thought you would reduce taxes, but at some point, there is a trade-off between saving taxes and no longer having money to spend on current needs. Or maybe, you like the idea of paying ZERO taxes in retirement and take the taxes now and save into a Roth 401(k). Or you might have a mortgage, which automatically allows you to deduct interest and property taxes. You might have children who go to daycare, and you get some deductions there…but it’s not as if you’re NOT going to use daycare or not have children if you didn’t get a deduction. So most of the tax “strategies” that people use for reducing taxes are things they are probably going to do anyway.The truth is, most of your tax story was set in stone months ago, and there is very little you can do now to change things for your 2020 tax return. Click To Tweet
The Panic Tax Strategy
The best thing you can do is to know roughly what you will owe in taxes at the start of the year and have a plan to withhold or pay (if you’re self-employed) at least that much over the year. That way, if you do qualify for a deduction, it’s a nice surprise instead of sticker shock when you complete your tax return.
I get a lot of last-minute calls from people who don’t have a 401(k) at work they can save into – in that case, you are able to make a last-minute decision before filing your taxes as to whether or not to save into your own Traditional IRA (you can also do a Roth if your income is under the allowable AGI limit, but that doesn’t change your tax bill). People will often email me on April 13th to ask if I think it’s a good idea — and I never do. Here’s why:
Let’s say you’re single and made $100,000 last year and weren’t covered by an employer retirement plan at work. I’m going to ignore for the moment all of the “should” issues of always saving for your retirement. And let’s say you don’t own a home, so you get the most basic standard deductions and exemptions. You would owe around $15,300 in taxes. But let’s say that, through your paystub, you only withheld $13,000 from paycheck to paycheck over the year… which means you would still owe $2,300 when you prepared your tax return.
This is when people think to themselves, “Oh crap! I better contribute to an IRA to reduce my taxes!” But guess what? Even if you did the maximum allowable contribution of $6,000 (this limit updates every few years), your taxes only go down from $15,300 to now owing $13,860.
So you STILL owe an extra $1,440 in taxes, except now in addition to that, you have to contribute $6,000 to an IRA before filing your tax return. Instead of needing to come up with $2,300 to cover the tax shortage, you must come up with $7,440 to cover the tax shortage PLUS the IRA.
What About Self Employment?
Now let’s pretend that person was self-employed and after self-employment expenses, net business revenue was $100,000. So now, s/he not only owes regular taxes but also self-employment taxes (because you pay both as the employee and employer when you’re self-employed) for a total of $24,195. So total regular taxes are $15,300 and additional self-employed taxes are $8,895 (this isn’t exactly right because technically, your regular Federal taxes go down because you get to deduct half your self-employment tax against income, but most people don’t care about that, just the total tax bill!).
So in this scenario, you say, “Oh crap! That’s a lot in taxes, maybe I should do an IRA contribution to lower that.” (Because you never set up a self-employed retirement plan for your business, you silly!). So again, you plan to do the $6,000 IRA contribution before filing your tax return. That will save you about $1,827 in taxes in this scenario. Notice, I didn’t assume any withholding for the self-employed person, but hopefully, s/he was making estimated tax payments throughout the year.
This is why it’s sooo important to track all your self-employment expenses…because they reduce your net income dollar for dollar before you get to deductions or the self-employment tax calculations. Some travel, meals, and entertainment are only deductible at 50%, but the point is to track everything carefully.
Where are you with your taxes? Have you done your tax return yet, or contacted a tax preparer? Is there anything you’re confused about and might need help with? Do you still need to gather your tax statements and documents? Block out 15 minutes this week to complete the next step for yourself.
Don’t stress. Honestly? The IRS customer service people are some of the nicest reps out there. Don’t stress if you owe and can’t pay right away, they are happy to help with a reasonable payment plan.
Look forward. How can you make this year’s taxes less stressful than last year? Can you save more in your paycheck? Bump up that retirement plan savings or other tax-advantage employer benefits?