It’s that time of the year when a lot of people are sitting on pins and needles wondering if they’re going to owe money when they file their income tax returns. Others know they will receive a sizable refund because they receive one every year.
What’s the right way? Should you minimize your income tax withholding and estimated tax payments to the government and owe a bunch of money when you file your tax returns or is it better to do the opposite and end up with a large refund? Does it matter at all?
Are you a lender?
Do you consistently receive sizable refunds when you file your income tax returns? If so, you’re unofficially in the business of lending, with Uncle Sam as your borrower.
Unless you incur no tax liability and receive refundable tax credits, such as the earned-income tax credit, your refund represents a return of your loan to Uncle Sam — without interest. The term of your loan begins on the day that you start advancing funds to the government in the form of withholding and/or estimated tax payments. Your loan ends when you receive your refund.
It’s all about planning
Generally speaking, there should be no surprises when you file your tax returns, provided that you’ve done income-tax planning. Speaking from personal experience, there have been very few significant differences between actual and planned results in the 35 years that I’ve been preparing income-tax returns for clients. Differences, when they have occurred, have generally been attributable to either unknown or forgotten items when we did tax planning.
The first step in income-tax planning is preparation of an income-tax projection. I recommend preparing a mid-year projection followed by an update in November or December in most situations. For all projections, you need to gather as much information as possible about year-to-date and projected income and deductions. Prior-year income-tax returns are a helpful starting point.
Your projection should generally include two or more cases. The first one should be a base-facts calculation of your projected income-tax liability and balance due or refund assuming that no changes are made in your tax situation between the time that your projection is prepared and the end of the year. “What if” cases should also be prepared to determine potential strategies that can be implemented to reduce current, and possibly, future years’ income tax liability.
State tax balance due may be a good thing
For those of you who pay state income taxes and itemize your deductions, one strategy that should be included in a “what if” case is an analysis of the timing of state income-tax payments. Assuming that you itemize your deductions, state income, local, real-estate, and personal-property tax payments are generally deductible.
There’s an exception, however, if you’re subject to the alternative minimum tax, or AMT. When AMT comes into play, a portion, or potentially all, of otherwise deductible tax payments lose their deductibility. In this situation, it may make sense to defer the payment of additional state income taxes and real-estate taxes to the following year, especially if you aren’t projected to be subject to AMT next year.
Plan for refund or balance due
The timing of payment of state income taxes is just one example of a strategy that can be evaluated when preparing an income-tax projection. Others should be analyzed to determine how current and future years’ income tax liabilities can be minimized.
Once you have optimized your projected income-tax liability, you should adjust your income-tax withholding and/or estimated tax payment amounts for the remainder of the year to approximate your projected liability. That is, unless you’re projected to be in an AMT situation, then it may behoove you to defer payment of additional state income tax to the following year.
Whether you owe tax or are due a refund, there should be no surprises when you file your tax returns — provided you’ve done your tax planning.
Robert Klein, CPA, PFS, CFP®, RICP®, CLTC® is the founder and president of Retirement Income Center in Newport Beach, California. Bob is also the sole proprietor of Robert Klein, CPA. Bob applies his unique background, experience, expertise, and specialization in tax-sensitive retirement income planning strategies to optimize the longevity of his clients’ after-tax retirement income and assets. He does this as an independent financial advisor using customized holistic planning solutions based on each client’s needs and personality.