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You would think it would be hard to persuade someone to put hundreds or even thousands of dollars into a savings account that didn’t pay interest and would allow withdrawals only once a year. Yet that’s what millions of taxpayers do when they overpay on their income taxes and receive a refund check.
Evaluating the accuracy of your income tax withholding is just one of the smart tax moves that accountants strongly recommend for taxpayers doing their mid-year tax planning, because it’s early enough to be the most effective.
The longer you wait, the harder it is to do any significant planning, get a baseline on your tax situation early so you don’t have any surprises when it’s too late to do anything about it.
A mid-year tax review should target:
How much you overpaid or owed on your tax return;
Changes in personal circumstances that may affect your taxable income and deductions;
Tax code changes that may impact the amount of tax you owe; and
Strategies to lower your taxable income that you haven’t taken full advantage of in the past.
Step 1: Revisit your withholding
Getting a big refund or having to write a big check at tax time are both consequences of the same problem — failing to accurately estimate how much tax you owe for the year. And neither works to your advantage.
Most taxpayers can avoid a penalty for under-withholding if they pay enough during the course of the year to cover at least 90% of their tax bill, or if they pay at least 100% of the tax shown on the return for the prior year, according to the Internal Revenue Service.
To change your withholding amount, have your employer revise your IRS Form W-4. If you’re self employed, adjust your quarterly estimated tax payments.
Get withholding help from IRS Publication 919, How Do I Adjust My Tax Withholding?
Step 2: Evaluate changes in circumstances
If you have already made or are planning to make major changes in your life, remember that they may have tax consequences. For example, buying a new home will likely lower your tax bill, because you’ll be able to deduct your mortgage interest and any “points” you paid when you took out your loan.
Similarly, a new child in the family typically generates an additional dependency exemption.
Another event with significant tax consequences is a child starting college. You might be eligible for a Hope scholarship credit for each enrolled child or a Lifetime Learning credit per tax return. If your income is too high to qualify for one of the credits, you might be able to claim a tuition and fees deduction.
See IRS Publication 970 for details of the education credits and deductions.
Conversely, you could incur a significantly higher tax bill if you sell stocks that have greatly increased in value, get a big promotion at work, or receive an inheritance.
Whatever the event, you should incorporate it into your tax planning as soon as possible.
Step 3: Be aware of tax code changes
Tax code changes can significantly impact how much tax you owe, yet many people aren’t aware of them until it’s too late to benefit — or to avoid their consequences.
The kiddie tax rules make it much harder for parents to shift a large amount of investment income into a child’s account so that it will be taxed at the child’s lower rate. The new rules specify that a child with unearned income totaling $2,000 or more part of that income may be subject to tax at the parents’ rate.
There is an exception, for children who have earned income that covers half of their support. (For purposes of the kiddie tax, support includes the fair rental value of lodging, clothing, education, medical care, transportation, entertainment, etc.) So parents with small businesses who can employ their children and legitimately pay them enough to satisfy the threshold may be able to limit the impact of the kiddie tax.
Many people are going to have to restructure how they transfer money to their children. That might include:
Opening a Coverdell Education Savings Account or 529 plan college savings account, in which the earnings are not taxed if they’re used for qualified higher education expenses;
Investing in equities more likely to generate long-term capital growth than current-year income; or Choosing tax-exempt or tax-deferred bonds.
Step 4: Take advantage of opportunities
If you find that you make a promise to yourself every year at tax time that you will put more income into tax-deferred accounts — but never following through — now is the time to make good on the promise.
We encourage clients to take full advantage of their 401(k) plans and IRAs to reduce their taxable income, At a minimum, it’s silly not to at least put enough in your 401(k) to get the full employer match.
Participants in 401(k) and 403(b) plans can contribute up to $18,000 in 2015. But it’s hard to get there, if you wait too long into the year to increase your paycheck contributions. Check in with your employer now to increase your payroll deduction.
Furthermore, we encourage clients who cannot contribute to a Roth IRA — because their income exceeds the contribution limits — to make nondeductible contributions to a Traditional IRA this year and next. Because, the income limit for converting a Traditional IRA to a Roth IRA disappears — currently only those with modified adjusted gross income below $100,000 could convert. So those nondeductible Traditional IRA contributions can be converted to a Roth, giving clients “a nice jump start,” because they will only have to pay tax on the earnings, not the principal.