Pick your deductions carefully
Okay, silly thing. It's tax time. Since becoming a contractor last year, I've been obsessed with my taxes. It's more the fact that I hate uncertainly. Unlike my mother's other son (who in matters like this, I prefer to refer to him as), I hate to find out at the end of the year either that I owe some huge amount (and they kill you if you have to pay a penalty!), or I get a huge refund back and I've essentially given the government a tax-free loan. (I will still say this mantra: a refund is just money you would have gotten back during the year before had you just increased your deductions! More on that later.)
Disclaimer: This isn't tax advice. Contact your accountant or tax adviser for more details.
That being said, now onto my findings.
Whether you have to pay in or get a refund, your tax bill is still the same. It just matters how much you've already had taken out of your check during the year that determines if you've paid too much or not enough.
At first, I had always gotten a refund. I had used it often towards paying things off, or perhaps contributing to my retirement account. Granted, if it's the only way you can save, there is that. But you could also increase your deductions and you would get a bigger paycheck, then sign up for an automatic savings plan to take out that amount. (Services like INGDirect will do this for you, and rates online are typically better because of lower overhead.) That way you're earning interest throughout the year, instead of the next year when you get your refund.
Then I heard, it's an interest-free loan to the government? Yup. As I said, owe or pay, your tax bill's the same.
So I said, well, I don't want to that. On the flip side, if you owe too much, you'll have a penalty. Well, how much is that? Generally, if you owe more than $1,000 and it's more than 10% of you total tax less some deductions. (See the 1040 instructions for details.) E.g., if your taxes are $20,000 and you owe $1,500 you probably won't owe a penalty. (More than $1,000 but less than 10%.) However, if your taxes are $5,000 and you owe $1,500, you probably will. (More than $1,000 and more than 10%.) If your taxes are $5,000 and you owe $800, you're probably fine. (More than 10% but less than $1,000.)
Also, if you've paid at least as much as the previous year, you're probably fine (unless your adjusted gross income is over $150,000, then it's at least 110% the previous year). That's helpful if your income (and thus your taxes) are rising, especially more than 10%.
Timing is also important. If you didn't pay on time (estimated taxes), you might owe a penalty even if you have a refund. Generally only those who have to pay estimated taxes have to worry about this, or those who don't have taxes taken out, such as the self-employed or those with unemployment payments.
Again, consult your adviser. These are just guidelines. Your results may vary.
So still with me? Okay, I don't want to give the government an interest-free loan and I don't want to pay a penalty, I've figured an amount I can pay in without paying a penalty. Now, I have to adjust my deductions.
So the whole reason I'm writing this is, how many deductions should I adjust my withholdings by?
For the longest time, I had never heard this answer. I had heard if you get a refund of more than $500, you should probably increase your deductions by the number of times $500 goes into your refund. But that's an estimate. I have the exact answer.
The what is the answer? For every additional deduction you take, your amount you owe will increase (or your refund will be reduced) by (drum roll please) the standard deduction times your marginal tax rate.
Again, your tax bill is still the same, it's just whether come April 15th you've paid too much or not enough.
The long answer is that the amount they take out of your check is that they estimate what your annualized income will be for that check minus deductibles they know about like 401k and health insurance premiums, and then subtract the number of deductions you've selected (to account for deductions they don't know about like state taxes and home loan interest) times the standard deduction, and then figure your taxes you'd owe on that amount. So if you increase by one the number of deductions, the amount they take out will decrease by the standard deduction times your marginal rate, de-annualized back by how often you're paid.
And at year end, that reduces your refund or increase the amount you owe by that amount.
Now, other things can affect your taxes (deductions, amount you make, etc.), and this is entirely an apples to apples comparison. It also assumes that you have the same amount of deductions for the entire year. Changing mid-year will result in a smaller change. And check-to-check changes affect it too. (A big check might have a bigger marginal rate, a smaller check might be smaller, etc.) So don't assume that the answer will be exact.
However, it is the most exact estimate I've never heard.
So for 2008, the standard deduction is $3500. Say, if your taxable income is between $32,550 and $78,850, your marginal tax rate is 25%. Increasing your deductions by one will reduces your refund or increase the amount you owe by $875. If your marginal rate is 28%, the amount is $980. 33%? $1155. You get the picture.
(What's my marginal rate? It's 10%, 15%, 25%, 28%, 33% or 35%. Check here. This is on taxable regular income, i.e. after deductions. Your taxable income is also line 43 on your 1040, but that's for the previous year, not what it will be next year.)
So if you're getting back $700 now, you'd owe $175 if had one additional deduction. But your paycheck would also increase by a proportional amount. (If you get paid biweekly, if would increase $875 / 26 = $33.65 per check.) Put that savings and not only will you have $875 in the bank come April 15th, you'll have that plus interest.
Likewise, if you owe $1000 now and your reduced your deductions by one, you'd only owe $125. Your paycheck would be slightly reduced (by that $33.65), but it could make that payment on April 15th less painful too. And by all means, if it means you won't get penalized, do it!
(Again, apples to apples comparisons. Other things affect your taxes, taxes change year over year, check your adviser, your mileage may vary, offer void where prohibited, yada yada yada.)
It all works out in the end. It's just math. And that's exactly why people fail to understand it. (Don't feel bad. I almost majored in Math and this is the first I've understood it.) I hope this makes a little more sense to people, and either make their taxes a bit less painful, or get you your money back long before April 15th, instead of on it.
Disclaimer: This isn't tax advice. Contact your accountant or tax adviser for more details.
That being said, now onto my findings.
Whether you have to pay in or get a refund, your tax bill is still the same. It just matters how much you've already had taken out of your check during the year that determines if you've paid too much or not enough.
At first, I had always gotten a refund. I had used it often towards paying things off, or perhaps contributing to my retirement account. Granted, if it's the only way you can save, there is that. But you could also increase your deductions and you would get a bigger paycheck, then sign up for an automatic savings plan to take out that amount. (Services like INGDirect will do this for you, and rates online are typically better because of lower overhead.) That way you're earning interest throughout the year, instead of the next year when you get your refund.
Then I heard, it's an interest-free loan to the government? Yup. As I said, owe or pay, your tax bill's the same.
So I said, well, I don't want to that. On the flip side, if you owe too much, you'll have a penalty. Well, how much is that? Generally, if you owe more than $1,000 and it's more than 10% of you total tax less some deductions. (See the 1040 instructions for details.) E.g., if your taxes are $20,000 and you owe $1,500 you probably won't owe a penalty. (More than $1,000 but less than 10%.) However, if your taxes are $5,000 and you owe $1,500, you probably will. (More than $1,000 and more than 10%.) If your taxes are $5,000 and you owe $800, you're probably fine. (More than 10% but less than $1,000.)
Also, if you've paid at least as much as the previous year, you're probably fine (unless your adjusted gross income is over $150,000, then it's at least 110% the previous year). That's helpful if your income (and thus your taxes) are rising, especially more than 10%.
Timing is also important. If you didn't pay on time (estimated taxes), you might owe a penalty even if you have a refund. Generally only those who have to pay estimated taxes have to worry about this, or those who don't have taxes taken out, such as the self-employed or those with unemployment payments.
Again, consult your adviser. These are just guidelines. Your results may vary.
So still with me? Okay, I don't want to give the government an interest-free loan and I don't want to pay a penalty, I've figured an amount I can pay in without paying a penalty. Now, I have to adjust my deductions.
So the whole reason I'm writing this is, how many deductions should I adjust my withholdings by?
For the longest time, I had never heard this answer. I had heard if you get a refund of more than $500, you should probably increase your deductions by the number of times $500 goes into your refund. But that's an estimate. I have the exact answer.
The what is the answer? For every additional deduction you take, your amount you owe will increase (or your refund will be reduced) by (drum roll please) the standard deduction times your marginal tax rate.
Again, your tax bill is still the same, it's just whether come April 15th you've paid too much or not enough.
The long answer is that the amount they take out of your check is that they estimate what your annualized income will be for that check minus deductibles they know about like 401k and health insurance premiums, and then subtract the number of deductions you've selected (to account for deductions they don't know about like state taxes and home loan interest) times the standard deduction, and then figure your taxes you'd owe on that amount. So if you increase by one the number of deductions, the amount they take out will decrease by the standard deduction times your marginal rate, de-annualized back by how often you're paid.
And at year end, that reduces your refund or increase the amount you owe by that amount.
Now, other things can affect your taxes (deductions, amount you make, etc.), and this is entirely an apples to apples comparison. It also assumes that you have the same amount of deductions for the entire year. Changing mid-year will result in a smaller change. And check-to-check changes affect it too. (A big check might have a bigger marginal rate, a smaller check might be smaller, etc.) So don't assume that the answer will be exact.
However, it is the most exact estimate I've never heard.
So for 2008, the standard deduction is $3500. Say, if your taxable income is between $32,550 and $78,850, your marginal tax rate is 25%. Increasing your deductions by one will reduces your refund or increase the amount you owe by $875. If your marginal rate is 28%, the amount is $980. 33%? $1155. You get the picture.
(What's my marginal rate? It's 10%, 15%, 25%, 28%, 33% or 35%. Check here. This is on taxable regular income, i.e. after deductions. Your taxable income is also line 43 on your 1040, but that's for the previous year, not what it will be next year.)
So if you're getting back $700 now, you'd owe $175 if had one additional deduction. But your paycheck would also increase by a proportional amount. (If you get paid biweekly, if would increase $875 / 26 = $33.65 per check.) Put that savings and not only will you have $875 in the bank come April 15th, you'll have that plus interest.
Likewise, if you owe $1000 now and your reduced your deductions by one, you'd only owe $125. Your paycheck would be slightly reduced (by that $33.65), but it could make that payment on April 15th less painful too. And by all means, if it means you won't get penalized, do it!
(Again, apples to apples comparisons. Other things affect your taxes, taxes change year over year, check your adviser, your mileage may vary, offer void where prohibited, yada yada yada.)
It all works out in the end. It's just math. And that's exactly why people fail to understand it. (Don't feel bad. I almost majored in Math and this is the first I've understood it.) I hope this makes a little more sense to people, and either make their taxes a bit less painful, or get you your money back long before April 15th, instead of on it.
posted by Joe Carlin at 8:50 PM
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