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Four Tips for Tax Season

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This is a guest post from Eric at Narrow Bridge Finance as part of the Yakezie Blog Swap. This week, we are discussing the topic “Best Tips for Your Taxes.” You can see my post on the same topic at Eric’s site.

 

 

People around the United States are in a last minute flurry to find their W2s, 1099s, 1098s, and find the easiest and cheapest way to load all of that onto a 1040. If that sounded like a foreign language to you, don’t worry. Here are some of my favorite tips for navigating tax season.

Tip #1 – File Early

I guess if you are reading this, you probably already missed this one. But there is no time like the present to start planning to avoid next year’s procrastination.

I sent my taxes to my accountant around the end of February. Avoiding the stress of last minute filing can do wonders for your health and sanity. Planning ahead and filing early just makes life easier on you.

Tip #2 – Understand Your Forms

Decoding that foreign language is important. Knowing which tax forms to look for is a big first step. Here are the most common items to look out for:

· W2 – Earnings report from your employer

· 1099 – Miscellaneous income forms. These include bank interest, investment income, and freelance income.

· 1098 – Deduction forms. If you pay mortgage interest or higher education expenses, expect 1098s that you can use to lower your tax liability.

· 1040 – This is the form that you submit to the IRS that summarizes your annual taxes paid, taxes owed, and any refund or additional payment.

Tip #3 – Stay Organized

My taxes this year were two inches thick. Getting everything from my banks, investments, employer, and other income sources is a chore on its own. To stay organized, I made a checklist outlining everything I was expecting and marked forms off as they arrived.

When the form arrived, via mail or online, I filed hard copies in manila folders by type. My personal forms went into one folder and each of my side income sources had its own folder.

Make sure to keep each year separate but filed away in case you need it. It is important to understand how long to keep bank statements and other financial records.

Tip #4 – Understand How Your Taxes Work

You pay taxes every time you get a paycheck. You earn money all the time, and you might not remember it around tax time. To make sure you file correctly and avoid penalties and audits, you should understand how your taxes work.

Take time to learn about itemized deductions versus the standard deduction. Take time to learn about tax brackets. Whether you use tax software to file or have an accountant take care of it for you, you should understand the complexities of your taxes in case you are contacted by the IRS and to make sure you are not overpaying.

Get To It!

Now that you know my best tips, get those taxes done. The filing deadline is swiftly approaching, and you don’t want to get in trouble for being late.

(Photo credit: Tax Sign – 401k, Flickr; Chance Card – OhioProgressive, Flickr)

The Roth IRA–Playing Games with Tax Brackets

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Our normal Friday Blog Post of the Week! segment will return next week.

 

The Roth IRA is a Swiss Army knife for financial success.

In our past wildly exciting posts about the Roth IRA here and here, some of the commenters on these stories have discussed the efficacy of the strategies presented by the Other Guy.

In short: is it worth all the trouble jumping through hoops to get as much money into the Roth IRA as possible?

In a word: indubitably (I’ve wanted to use that word since I heard it in Mary Poppins. 10 points!)

While I’ll agree that if the only upside to these strategies are immediate returns on a few exotic Roth IRA gyrations, you’ll only gain a few extra dollars in your pocket for what seems like a lot of work.

…and I get exhausted switching television channels, so let’s not talk about work.

I prefer easy and exciting.

The Roth IRA has one exciting feature beyond those we’ve listed previously—flexibility later in your planning.

 

The problem with financial planning

 

When I read well-meaning blog posts about retirement or education planning (including my own), the writer always discusses assumptions.

You know what happens when you assume…but what choice do we have?

We’ll have to assume that the tax rate will go up/down/stay level.

We have to project inflation rates.

Finally, we have to decide when we’re going to die. (Well, at least you do…I’ve got my cryogenic tank next to Walt Disney ready to go. I’m gonna live forever.)

Back on point: Roth IRA plans, for those of you uncomfortable with this type of tax shelter, give you no tax break today but offers tax free income down the line. Many (yawn) dissenters say that tax treatment of a Roth IRA is irrelevant. You’ll pay the tax today or tomorrow. It’s all the same.

No it isn’t.

We’re working for maximum tax flexibility, not a few random bucks. Because I can’t predict income tax rates, capital gains rates, or estate tax rates, I’m going to create a financial future that is as flexible as possible, as soon as two current criteria are met:

– I’ve done what I can to maximize deductions today. I know what tax rates are right now, so I’ll take my tax break, thank you.

– I’m not locking up money unnecessarily for down the road when I’m experiencing short term needs for cash.

 

Here’s the Roth IRA Game

 

When you reach retirement, let’s pretend you want to live on $60,000. Tax brackets in America are tiered, meaning that you’ll pay 10 percent on the first dollars you make, until you hit the 15 percent bracket, which is what you’ll pay beginning with the first dollar in that bracket, until you reach the 25 percent bracket…..

Because we don’t know what tax brackets will be in the future, let’s pretend the 25 percent line will be at $50,000.

 

You Have Two Pots of Money

 

Most people have a pre-tax retirement plan. As I mentioned, I like my current pretax deductions, so I’ve maximum funded those. Therefore, I have monster amounts of money (otherwise known as oodles) inside of them. These dollars must come out of the plan and get taxed.

I’ll remove $50,000 per year from this plan. Some of it will be taxed at the 15 percent bracket and some at the 10 percent bracket.

 

Here’s Where the Roth IRA Comes In

 

Finally, I remove $10,000 from my Roth IRA. Now I’m living in the 25 percent tax bracket but the government is taxing us at the top of the 15 percent bracket.

 

Lots of Work for Big Payoffs

 

Now, I’ve avoided a 25 percent tax each year (or whatever my top tax rate would be….) on $10,000, or $2,500 in taxes. Of course, I paid those taxes already, but remember, if I’m worried about the HUGE AMOUNT OF WORK this takes, I’m only investing money after I’ve already secured current tax breaks.

(photo credit: Swiss Army Knife: IK’s World Trip, Flickr; License Plate: Gamma Man, Flickr)

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The Worst of the Free Financial Advisor #2: Top 5 Reasons We Like the Roth IRA – Are Tax Refunds Bad? – Hiring an Advisor

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Holy big topics, Batman! We’ve got a great show for you today.

First – Joe & OG talk Hiring an Advisor. Should you hire one? If so, what should you look for? What questions should you ask?

Then – Len, Carrie, Dom  and of course Dr. Dean discuss tax refunds. Should you avoid one?

Finally – Our top 5 reasons we love the Roth IRA.

Subscribe to the show (or just listen) on iTunes here.

Download the show directly by right-clicking here.

 

Hiring an Advisor

FINRA.org BrokerCheck

CFP – Questions to Ask When Hiring a Financial Planner

5 Jaw-Dropping Financial Advisor Interview Questions

Ric Edelman: The Truth About Money (Amazon page)

Our Roundtable Members Sites:

Carrie Smith = CarefulCents.com

Dominique Brown = YourFinancesSimplified

Dr. Dean = The Millionaire Nurse Blog

Len Penzo = Len Penzo (dot) Com

The Squirrelers.com article we’re discussing: Tax Refunds Are Not Taboo

 

 

 

 

Emergency Fund or Roth IRA?

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If you’re teetering on the edge of a trip down investing lane–but aren’t sure that you’re ready to begin locking money away–a Roth IRA just might be like two tickets to paradise. Pack your bags, we’ll leave tonight.

I just made that up. I know it sounds familiar. Deal with it.

Unlike its nasty cousin, the “For Retirement Only With a Couple Exceptions” Traditional IRA, a Roth has some attractive properties for people who need money in a safe place but are thinking “I’d like to start slipping some cash into a retirement account.” Two tickets to paradise.

Of course, this paradise has some weeds, but what do you want? I never promised you a rose garden.

Just made that up, too. I know…it’s a gift. Thank you.

 

Paradise Ticket #1: Emergency Fund

 

While it still makes absolute sense to have “need it right now” money outside of a Roth IRA, here’s the magical property that makes this shelter a fine second tier cash reserve emergency fund: you’re allowed to take principal back out whenever you want. If you remove funds contributed during the current year, it’s as if you’d never made a contribution in the first place. If it’s beyond the first year, you may take out up to the amount you’ve contributed.

That’s awesomesaucewithacherryontop because if you need money quickly, there’s no reason why you can’t access the cash you contributed.

Before you fight me on this, let’s work through it logically:

– When you make a Roth IRA contribution, do you receive any immediate tax benefit? No.

– How can the government penalize you for something that you received no benefit from? They can’t.

You want proof? Okay, here’s the IRS applicable document, Publication 590, Individual Retirement Arrangements. Check out the chart on page 63 and then the ordering rules on page 64.

More proof? At the bottom of the page I’ve included links to two less well written articles than mine. No charge.

When will you get into trouble? If you try and take any interest the account has earned, you’ll pay penalties to receive this interest unless it’s been in the account for five years and you’re 59 1/2 (whichever is later) OR qualify for one of the few exceptions to the penalty (you’ll still pay tax on the money when you withdraw it).

 

Paradise Ticket #2: Retirement

 

If you don’t end up needing the money, because your car didn’t break down, junior didn’t need to be bailed out of jail (again), and the dog stayed out of your neighbor’s trash bins for a change, this money can be used for retirement. At some point, once you’ve completely secured the reserve, you can switch these funds into more appropriate investments for retirement.

Ultimately, of course, this is what a Roth IRA should be used for: retirement savings. By easing into the Roth IRA plan, you’ll build the account early so there’s plenty of money available when you’re ready to begin in earnest.

Like Steve McQueen you’ll have a fast Roth IRA machine and they’ll never catch you tonight.

 

The Downside

 

Oh, yeah, you weren’t thinking about having a Roth IRA as your only emergency fund, were you? A Roth IRA is, to put it bluntly, an absolutely rotten place for a first tier reserve.

Here’s just a sample of our problem:

–  Remember when I said you can get money in a hurry? It’s not like the payday loan shop down the street or Louie on the corner. If your money is at an institution close by (like a neighborhood bank), you can probably take out funds now. If not, you’ll either have to wait for money to be transferred to a non-IRA account or until they can mail you a check. That’s not instant money. It’s “we’re going on an emergency trip to visit ailing Grandma in her cottage in the woods, and I paid for it with my credit card but don’t want to pay interest on the charge” money.

– If you take out all of your principal, you’ll only have some interest in the account. This money MUST stay in a Roth IRA for five years or until 59 1/2, which ever is later (as mentioned above). To take it out early, you’ll pay an IRS penalty. Although this may be a negligible amount on a small interest amount, it’ll make your tax return more complicated.

For these two reasons, I wouldn’t start a Roth IRA as your main emergency fund. Instead, only use it as second tier money.

 

What Type of Investment Should I Use, Joe?

 

It’s your cash reserve, silly. We don’t want to use anything that fluctuates at all. I know interest rates are poor, but if you’re only beginning, you’ll need the highest paying account the bank will allow while still keeping your money safe.

Don’t lock up the funds in a CD or you won’t be able to access the money, ruining why you used this strategy in the first place. It has to be a liquid account, like a savings account.

Once you have enough, transfer your money to a higher paying money market. Often this is between $500 and $2,000.

As soon as your cash reserve emergency fund is full, begin saving money into real retirement accounts that match your long term goals. Use a 401k for tax advantages today. Open a 529 plan for your children’s college.

Before long you’ll have so much cash they’ll be lining down the block just to watch what you’ve got.

So delicious.

 

How to Get Money In There Without Stealing It

 

The only way you’ll successfully save money is if you leave it outside of those pockets of yours. You know the ones. The I-can’t-hold-cash-for-longer-than-a-couple-minutes-without-spending-it pockets. Instead, make saving a bill.

Better yet, make it an automatic payment bill.

By setting up an automatic payment into your account you won’t have to remember to fund your account. Instead, money will flow directly from a checking or savings account into the Roth IRA, building it while you focus on other areas.

If possible, set up a separate direct deposit into your first tier reserve at your bank and then an automatic payment from the first tier reserve directly into the Roth IRA reserve account. That way, you’ll never have the money in your hot little hands.

If you want money in your hands AND to make Roth IRA contributions systematically, it’s going to be much harder, and there’s a good chance you’ll fail.

You can’t always get what you want. But if you set up an automatic payment plan you just might get what you need.

 

A Good Strategy

 

Once you’ve achieved your first tier reserve ($1,000 fast if you’re a fan of the bald dude on the radio, or other similar “quick cash” amount), split your automatic investment between your first tier reserve and a Roth IRA. This will help you ease into the investment world without the fear that the money is untouchable.

I’ve used this plan with nervous beginners to help calm them into rolling toward doing the right move: investing in their 401k where the money IS untouchable. It’s a good way to ease your mind.

…and before you know it you’ll be on your way to a million dollars. Then you could buy yourself a green dress.

But not a real green dress; that’s cruel.

No, I can’t stop.

 

 

Other Documents That Totally Agree With Me:

The Motley Fool: All About IRAs

My Money Blog: Can I Really Withdraw My Roth IRA Contributions at Any Time Without Tax or Penalty?

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How to Pay an Ugly Overdue Tax Bill

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I just read that Christie Brinkley owes over $500,000 in back taxes. That’s an ugly place to be. Sadly, I’ve been there before (not $500,000, but still a sizeable chunk of money). I’d like to share that story here.

When I began advising people about money, my background was similar to the many professional athletes who become financial advisors: I had no training. I was exactly “that guy” the pros and financial books warn you about when they say “don’t hire the new advisor.” Sure, I’d passed a few tests and took classes sponsored by the company I was going to work for, but I’d been an English major in college with an emphasis in creative writing. Talk about “not in Kansas anymore.” I wasn’t even on the same planet.

Why I’m An Expert In This Area

So, there I was, learning quickly. My paranoia about my lack of knowledge and the ability to “dumb down” difficult financial concepts helped me with early success in my new field—probably because I was coming at those concepts from a similar non-finance point of view. I hauled in a nice income. I had a great relationship with my clients. If I didn’t know something (which was often), I said “I don’t know, but I’ll find out.” That happened a ton.

Here’s the bad part of the story. I was a 1099 independent contractor. (For those of you unfamiliar with “1099”, it means that I didn’t actually work for the company. Because I was technically independent, zero taxes were taken out of my compensation. Without an knowledge of the full impact of not paying taxes, this was a financial meltdown ready to burst.)

Near the end of my first awesome year a friend said, “Who is your accountant?”

Me (thinking): “Dude, I should get one of those!”

So, I did. I found a guy named Tom. He was a great number-cruncher, but a horrible financial coach.

Tax guy Tom: “You owe $26,000.”

Me: “WTF?”

Tax Guy Tom (clueless): “Do you want to attach a check to the return?”

Me: “WTFFF????” I’m pretty sure I yelled. Yeah, I screamed. I should have been screaming at myself. It didn’t matter. He couldn’t believe I was dumb enough to spend every penny of the money I’d made. The funny part now is that I had used all that money to pay down debt.

I’d committed every stupid mistake in the book.

So, what did I do? I made the brilliant decision not to file my taxes, thinking that I’d find a way to catch up.

Note to the world: It doesn’t work that way. You can’t catch up.

So, Christie, I understand an overdue tax bill. I know that today you say that it’ll all be paid quickly. That’s good. If you can’t, or if any other reader is in a similar situation, here’s what to do.  This is what I should have done:

Joe’s Awesome 7 Step “Get Your Overdue Tax Bill Paid” Plan (or “Here’s What I Did”)

1) Find good tax advisors. My advisor helped me file back taxes and face the music. By avoiding the overdue tax bill, it was becoming bigger and more difficult to pay. I thought I was finding a “good” advisor when I met Tom. ….but, had I known how to ask questions, it would have gone smoother. AND I should have known to interview more than one person. I found a guy with lots of pretty letters after his name and hired the first one. I needed someone who could walk a beginner through the process of receipts and “what’s deductible and what ain’t.”

2) Communicate with the IRS. You need to face the music sooner or later. What surprised me is how easy the IRS people were to talk with. I was ashamed of my overdue tax bill, but they deal with people that have late taxes all day, every day.

Here’s a tip: the IRS phone line gets busy, so if you’re going to call, do it right after they open. You should get right through (I now call whenever I have questions or am feeling lonely). In my case, they knew promptly what programs to point me toward. Why did I call the IRS? My tax advisor told me to call them. She said it would help me stay on top of the situation. She also talked to them from time to time. (I had to sign a paper giving her the limited power to discuss my personal tax situation with the IRS first.)

3) Decide which method works best. There are two general directions you can decide between if you can’t pay the entire overdue tax at once. First, you can opt for an offer-in-compromise. This is a settlement with the IRS to pay less than your bill. I couldn’t go this route because (as my tax advisor explained), I had a high income stream and there was a good probability—in the IRS’ eyes—that they’d be able to collect the whole amount sooner or later (it was going to take me 30 years, but they don’t care. They may be nice, but those IRS zombies live forever, apparently.—I HAD to have one IRS joke in this piece….). If you owe less than $25,000, you can apply for an installment agreement, and will usually be accepted as long as you haven’t been a repeat offender. For amounts more than $25,000, the IRS is a little more like a nervous loanshark. You’ll have to fill out some extra paperwork.

4) Fill out the appropriate paperwork. Here’s a link to the IRS page describing all the appropriate tools. Before anything, you need to file the appropriate tax forms, if you haven’t already. Once that’s done, if you owe more than $25,000 on your overdue tax bill (like I did), you’ll need to fill out Form 433F, the Collection Information Statement. If you’re pursuing an installment agreement, complete Form 9465, Request for Installment Agreement. For an Offer in compromise, read IRS Booklet 646. It explains thoroughly the process of applying to reduce the amount you owe the government.

5) Be prepared to pay a fee to set up the agreement. As of this writing, direct debit and online payment plans cost $52, while payroll deduction plans run $105.

6) Wait for an answer from the IRS. They’ll respond in writing. If you called the IRS as I recommend above, you may receive an answer while you’re on the phone with the agent.

7) Realize that speed is your friend. Confronting the pain today is better than waiting. If you’ve managed to accumulate $500k in debt, you’ll owe interest and may owe penalties if you didn’t communicate effectively with the IRS.

Forms Needed:

IRS Collection Information Statement, Form 433F

IRS Installment Agreement Request, Form 9465

IRS Offer in Compromise booklet 646

Have a tax issue you’d like to discuss? While AverageJoe and TheOtherGuy aren’t tax advisors, we can point you toward resources and strategies. Use the comment section below or email me at joe (at) thefreefinancialadvisor (dot) com.

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Two Simple Steps to Tax Savings

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What???  What do you mean it’s tax time?  That’s not until January when my W2’s come in the mail, right?

My readers are very, very smart, but on this topic, if you were thinking the above, you’re in for a wonderful surprise.

Not as wonderful as a surprise flash mob at Walmart, but still, pretty awesome.

Tax season starts today. Happy tax season! I know. And you forgot to dress up for it.

Between today and the moment the ball drops in Times Square on 01/01/12 at 12:00 a.m. is the only time you have to make changes to your tax situation.  Sadly, most people begin planning for taxes when there is absolutely nothing you can do to create more tax opportunities.

Well, you’re in luck.

I’m going to bequeath unto you some tax-saving ideas you can easily implement over the next 60 days.

It could save you $725 or more.  Cool?  Let’s begin.

Remember, it’s about execution – not strategy.  You have actually DO something…(I know, I know….I’m a task-master).

Strategy #1 – The easiest way to chop $600 off your tax bill

If you have any investments outside your retirement plan, you’ve seen their values rollercoaster over the last few weeks/months as the market’s been pretty range-bound.  If you have a stock or fund you like, but it’s performance leaves a bit to be desired, consider selling it.  Wait 31 days and then buy it back.  If you have a loss, (up to $3,000 per year) you can claim it on your taxes (first against gains, then you can just use it as a deduction).

Neat, huh?  I love saving money.

If you’re not sure how this works, here’s an example from your favorite blogger:

You bought 500 shares of Ford stock (ticker: F) at about $20/share earlier this year.  That means you invested about $10,000 (I’m crazy about math!).  Today, Ford is trading around $11/share.

You believe in the company so you still want to own it long-term.  Fine.

Here’s what you do:

Sell your 500 shares today @ $11/share.  You just realized a $4,500 loss for tax purposes.  In 31 days, you’ll buy it back.  In the meantime, so you don’t miss out on a potential run-up on Ford shares while you’re out, go buy CARZ, an Exchange Traded Fund that focuses on the auto industry.  When the 31 days are up, sell CARZ and re-buy F.

Congrats.  You just saved yourself ~$600 on your taxes (assuming you pay around 25% tax rate).

Strategy #2 – The most-used deduction plus an extra 8%

On average, the most used tax-deduction is the mortgage interest deduction.  So, how about getting another 8%?

Here’s how:

When’s your mortgage payment due?  If you’re like me, it’s due on the first of the month.  If you use automatic payments, this bill is probably deducted from your checking account each month on the first.

Call your mortgage company and cancel the automatic deduction.

Instead, go online on 12/31/2011 and make your 01/01/2012 payment.  Check with your mortgage servicer to make sure it doesn’t need to arrive even earlier to post by 12/31/11.

Here’s what this five minute exercise created:

Let’s assume your payment is $1,000/mo of which $500 is interest (the deductible part).  Under a normal year, you would have $6,000 of mortgage interest to write off ($500 x 12 mo – $6,000).  By making your January payment early, you added another $500 interest payment.  So now you have $6,500 (or 8% more than $6,000) worth of deductions.  Again, assuming you’re paying around 25% taxes, you just saved another $125 in taxes due.

So, all-in-all, Average Joe just made you $725.

You’re welcome.  Don’t go wasting it on doughnuts.

Have a favorite tax-time tip to share?  Comments are open for our tax-time show-and-tell below!