Most Americans will be getting a tax refund this year. The Internal Revenue Service states that 58 percent of Americans that file a tax return will get a refund. The average refund that will be issued is $2,900.00 in 2013. So I ask the question, why in the world would you want to get a tax refund?
For some reason, everyone wants a tax refund. In fact, some people over withhold throughout the year in order to get a big refund. Clients have told me that they view this as a savings account. They would rather have the IRS hold on to their money. All of that is fine, BUT you are letting the IRS enjoy the use of YOUR money. Who knows what they are doing with YOUR money. If you are getting a refund, you are giving the Government an interest free loan. It’s true. Here is an example that I always give to my clients; “give me $1,000.00 today, and a year from now, I will give you that $1,000.00 back. In a year, I would have invested that money, and made a 4% return on my investment. However, you received nothing except your initially $1,000.00.” Does that sound fair? That is what you are doing if you are getting a tax refund.
In the United States our tax system is a “pay as you go,” tax system. What that means is that periodically you are required to make estimated income tax payments, either through your paycheck, or through Form 1040-ES (Estimated Tax Payments). The law says that all you are required to do is pay 100% of what your tax liability was in the previous year to avoid a penalty. The amount is 110% for higher income levels. If you don’t meet these minimum thresholds you will be charged a penalty. The amount of the penalty all depends on the amount that you under-withheld.
I want to point something out; paying 100% or 110% of your income tax liability from the previous year doesn’t mean that you won’t owe any money by year end. The odds are that you probably will owe some money; however you will not owe a penalty for underpayment. To find your tax liability from the year prior, look on page 2 of Form 1040. Line 61 says “total tax,” that is your tax liability.
Armed with that information you should adjust your withholding accordingly. With the additional money added to your paycheck each week, there are a lot of things you can do. The first thing you should do is invest the difference into a Roth IRA, if you meet the adjusted gross income (AGI) limitations for a Roth. The AGI limitations for a Roth IRA are $188,000.00 for married couples and $127,000.00 for single individuals. A Roth IRA is an individual retirement arrangement that allows a taxpayer to make after-tax contributions. As long as the contributions stay in the Roth for five years or more, withdrawals from the Roth are tax free. If your income is higher than the income limitations are for a Roth, then you can put the additional money in your 401(k).
The question is; how is AGI calculated. First we begin by calculating gross income. Gross income is money you earned through wages, interest, dividends, rental and royalty income, capital gains, farm income, unemployment, pensions, other income, and alimony.
Now that we have gross income, we have to subtract certain adjustments. Generally, adjustments come from “above the line” deductions discussed earlier. These can be contributions to Traditional IRAs, moving expenses, alimony paid, one half of self-employment tax, self-employed health insurance, and student loan interest. The difference between gross income and your adjustments is adjusted gross income.
The income limitations for a Roth IRA, can make a contribution to a Roth disallowed for higher income individuals. If your AGI is in excess of $127,000.00 in 2013 for an individual or $188,000.00 for a married couple in 2013 you are unable to contribute to a Roth IRA. However you can contribute to a Roth 401(k).
Something that is relatively new with 401(k) plans is a Roth 401(k). There are no income limitations with a Roth 401(k), and you can contribute up to $17,500.00 in 2013 to the plan. Individuals 50 or over can add an additional $5,500.00 to that contribution for a total of $23,000.00. Unlike a traditional 401(k) contribution, these contributions are made after tax, but the same rules that apply to Roth IRAs apply to Roth 401(k)s.
With the extra money that you are saving through lowering your withholding, you can put the money into tax free bonds. Tax free bonds are typically municipal bonds which are issued by State and Local governments. How they work is you lend money to a government and they pay you interest on your investment. The interest that is paid is tax free to the owner of the bond.
Another popular investment is Treasury Bills or T-Bills. When to you invest in T-Bills, you are lending the Federal Government money, and in turn they pay you interest. The interest that you receive is tax free.
Another potential investment that you can make is in the stock market. There are various companies out there that will allow you to invest in small increments.
Whatever you do with the money that you are holding onto, is much better than giving it over to the Federal Government to hold.
For more information visit www.smalleynco.com
If you have any questions you can email Craig W. Smalley E.A.
Author of the books: It Starts With an Idea – Tax Tips for Small Businesses, The Ultimate Real Estate Investor Tax Guide, The Complete Guide to the New Tax Law – American Taxpayer Relief Act of 2012, Everything You Wanted to Know about the IRS – Audits, Appeals and Collections, Tax Avoidance is Legal! The Complete Guide to Individual Income Tax, The Complete Guide to the Affordable Care Act’s Tax Provisions, The Complete Guide to Retirement Plans for Small Businesses, The Complete Guide to Estate, Gift and Trust Taxation, The Complete Guide to Hiring an Accountant, The Complete Guide to Subchapter S-Corporations,, and Free Money. All available exclusively on Kindle