Tips for Proactive Tax Planning

Do you love getting a large tax refund every April? It's something many people have certainly enjoyed in years past. However, it's also the equivalent of giving an interest-free loan to the Federal (or state) government every year when you could be using those funds now.

On the other hand, it is important to be sure you're paying enough in taxes upfront every year. Did you know that you can even be assessed a penalty for not paying enough in tax during the calendar year? As an example, let's say someone paid no taxes during the year but paid their balance in full that next April. Unfortunately, this person will have to pay a penalty in the form of an interest assessment on the balance that they would have (and should have) paid the previous year, even though the balance was paid in full in April.

It's important to get the tax payments just right so you pay enough in taxes to avoid any penalties, but not so much that you're getting a large refund every year. To make it even more complicated, you can even be penalized if your tax payments don't align with the quarter you earned the income. This is usually more applicable to those who are self-employed or retired, but still something for which to be on the lookout.

There are a few ways to make your tax payments. If you are still working, you can withhold from your paycheck, withhold from other income sources (i.e. pensions, Social Security, or even IRA and retirement withdrawals), or make quarterly estimated tax payments.

While you are working, tax withholding is fairly straightforward. You likely filled out a Form W-4 when you were first hired. Your employer withholds the taxes directly from your paycheck and all the details are reported on a Form W-2 at the end of the year. Make sure you withhold the correct amount. This is something your financial planner actively checks as part of your yearly tax planning.

The options are more complicated for the self-employed and retired. You can set up tax withholding on other fixed sources of income such as Social Security, pensions, deferred compensation, and withdrawals from retirement accounts. Remember to look at the whole picture when setting up your withholding amount. For example, let's say you have a large capital gain from the sale of stock this year. As you are not generally able to withhold any taxes from the proceeds of a stock sale, you may have to increase your withholding from another source of income to compensate for the large capital gain.

You can also make quarterly estimated tax payments. Typically, you first review your projected income for the year and then determine how much you need to pay each quarter. Your accountant will likely give you an estimated tax payment notice, which you'll send in with your check each quarter. It's easy, in the business of life, to let the deadlines slip, so be sure you mark the due dates on your calendar.

Taking into account these different options, we're frequently asked which is the best payment method. As part of our planning process, we complete an analysis of your entire tax picture for the year and help you determine how much you may owe. Once we have that figure, we look at the different options you have and help you select the best one.

Generally, we believe that withholding from income is more convenient than making estimated tax payments. There are no extra checks to write and it's one less thing to remember. An often unknown option is to withhold taxes from most IRA or retirement account withdrawals. This is especially applicable for those over age 72 who are required to take a minimum amount from their IRA annually (whether it's needed or not). You can withhold federal taxes directly from an IRA withdrawal. Most states, though not all, also allow you to withhold. If you elect to withhold from an IRA withdrawal, you receive the usual tax form at the beginning of the following year (a 1099-R) which shows the total amount you withdrew and the total amount paid in taxes (just like a W-2). Another benefit of withholding taxes from an IRA withdrawal is that regardless of when the withdrawal is taken, the tax is considered to have been paid evenly throughout the year.

The below illustration compares withholding taxes from income vs. making quarterly estimated tax payments. In this example, we assume this individual files as Married Filing Jointly, but the principle applies regardless of your filing status. Notice the total due in tax is still the same, regardless of how you make the payments.

Proper proactive tax planning helps avoid many unpleasant surprises and outcomes in the future. Always remember to keep us abreast of any upcoming changes that may impact you financially.