Here is a question to ask yourself after tax season is over. What really happens during a typical tax season for a family or business? I have been doing this for over 20 years, and so let me describe to you the typical outcomes.
The first thing that we see is that most people cross their fingers and say three Hail Mary’s hoping for a refund. Does this sound like you? You gather all of these documents that you get from your employer, your investment companies, and real estate you own, then you hand them over to somebody (an accountant or CPA) and pray that they’re going to get you some money back so you can go on that vacation or remodel your house. Most individuals that we meet who get a federal refund during tax time think that their CPA is the bomb. They are assumed to be the smartest, brightest, and most unbelievable individuals in the world. It’s funny how human emotions can play tricks on our mind.
However, if they owe money to the government at the end of the year, most people are either . . .
A. Mad at their tax software, or
B. Mad at their CPA thinking that they have done something incorrectly.
Most people define the quality of the work their CPA performed by the amount of the tax refund and by the size of the package that you get in the mail at the end of the tax season. Everyone is always so enamored by this big blue book they get with all of their documents and tax return that it kind of makes you believe your accountant did a lot of work. In fact, most of the work is done by simply filling out the packet that they sent you in January. And then whether people owe money or they get a refund, they go into their cave like a big bear and hibernate only to repeat the process in the next tax season. This is exactly what tax preparation is. It’s what most people do and it’s really a historical account of what’s happened. For example, if you are filing your taxes in 2012 for the 2011 tax season and try to come up with ideas in April, you’ll likely be behind the 8 ball and have a very limited number of last second options if you owe money.
Tax planning is exactly the opposite. Now that you have finished taxes in April, what you should be doing is sitting down somewhere between May to October with your accountant, or if you don’t have an accountant, you should be doing it as a family and planning out the year ahead. If you file an extension, you will have to do it later in the year and start to think about what the rest of this year is going to look like. Ask yourself early in the year, what you can do now so that when you file in the next season you can reduce what is owed to the government. Remember that planning is a proactive process in general. It’s not a reactive process, and it’s all about looking about what happened last year, what changed for you personally, what may have changed in the tax code, and putting together a game plan to be successful. If you make a New Year’s resolution and you describe that you’re going to go on an exercise or diet plan, wouldn’t your success be about planning? You either join some program where you pay money and they set you on a program or you create a program on your own, but you generally don’t lose weight or get in really great shape and look back and say wow, I can’t believe that happened. It’s done on a proactive basis and tax planning is done the same way. I want to share two stories with you about a bad situation and a good situation to show you the difference in tax planning versus tax preparation.
Here is how to do it poorly:
The first story I want to share with you is a one of somebody I met that became a client after they had a bad experience with another company, and how by doing tax preparation versus doing tax planning they failed in their overall situation. We had a single woman that we met who was doing very well in her career. She was at the point that where her earned income was over $200,000 a year. She lived in a major metropolitan city, she owned a home, and she was putting some money into her 401(k) plan. When she did her taxes two year ago, she got herself about a $1,200 refund with all of her deductions. (As a side note: refunds are not always a bad idea to jumpstart a savings especially if you can’t save regularly.) Having your tax return come up with a zero instead of owing or getting a refund would be the most optimal situation. Generally if you’re within $1,000 one way or another, you either owe $1,000 or get $1,000 refund, you’ve done a pretty good job of tax planning.
In this case, she got a $1,200 refund, which was not bad. One of the reasons that she did well and got this refund is that she owned a home, as well as was putting some money in her 401(k) plan. This woman got a tremendous job offer for a major company in New York City shortly thereafter. She took this job and she got a pay increase of about $30,000. And then, in April of the prior tax year she sold her home, and moved into New York City. In NYC with the cost of housing so high, she decided to rent versus buying an apartment. She was still putting money into her 401(k) plan.
However, when tax time came the following year, she was flabbergasted to learn she owed about $6,000. Needless to say, she couldn’t understand why this happened to her and where the disparity came. Although she took out the same amount of withholdings out of her paycheck and she was still putting money in her 401(k) plan, she failed to ever think about the deductions that she lost from her house. No more real estate deductions for the real estate taxes, there was no home mortgage interest deduction, etc. Consequently, by losing those two deductions, it made a swing of about $7,000 in her overall taxes. She never calculated for that major change in her taxes as she was just too busy at work. Subsequently, she was really upset at the end of the year because she owed $6,000 in taxes. When we went back and showed her what happened, she realized she needed to use something different. Now we’ve gotten her on the tax-planning track. But this is a great example about how situations change, either in the tax law or personally, and by not doing tax planning, how it can potentially cause you major issues.
Here is how to do tax planning well:
Here is a good example of how to do tax planning versus tax preparation. We met two people that recently got married. They had a wonderful situation. The husband was making about $300,000 a year and the wife was making about $200,000 a year. Both of them were maxing out their 401(k) s and saving money on a regular basis. They got married in the spring of the prior year, and came to us in about May saying, “Hey, we just got married; is there anything we should be thinking about differently?” Well first things first, when you get married and you file married, the tax bracket looks slightly different than they do when you’re single, so the first thing that we did was look at their withholdings and turn it into a married perspective instead of a single perspective. Many newly married couples never change their withholdings at work. So, based on a married couple now making $500,000, we took a look at the withholdings and adjusted them. The second thing is that at their income level, we started talking to them about what tax credits may be available. Ideas like conservation easements, low income housing credits, historic rehabilitation credits, or other things that may reduce their gross income to make a smaller adjusted gross income or provide tax credits to give them a smaller tax liability. We also looked at a state level as well. We took a look to make sure they were maximizing all of their pre-tax opportunities at their employers. We took a look at tax exempt investments versus taxable investments, or other ways that they could defer, shelter, or reduce their overall income, including setting up a business. At the end of the day, when we got to the following year and we prepared their taxes, guess what? There were no surprises. We planned out accordingly, and they actually got a small refund from the government. This is a great example that if you sit down in the middle of the year, when you have job changes and family changes such as divorce or getting married or you have a baby, there are opportunities to reset expectations about how you do your tax planning. Those that do this end up being a lot more successful than those that do not.
Now more than ever, you have to take matters into your own hands. If you are paying someone to help you sort all of your tax matters out, then tax season shouldn’t be a big surprise. If you are the type of person that says a prayer every year for a big refund, here is my smart money moves advice. Begin your planning right after you file your taxes here in 2013. If you start now, you’ll know your outcome when your file in 2014. More importantly, you can probably deploy strategies today that help you keep more of what you make.
CFP®, AAMS®, AWMA®, CRPC®, CMFC®, CRPS®
Editor in Chief of Your Smart Money Moves
Co-CEO and Founder of oXYGen Financial, Inc – The Leaders in Gen X & Y Financial Advice and Services
Ted Jenkin is one of the foremost knowledgeable professionals in giving financial advice to the X and Y Generation.
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