As tax season starts to wind down (or speed up, if you are trying to beat the filing deadline), it’s a good time to reflect on what you should know about paying taxes, and how you can streamline the process. Even if it’s too late for this year’s tax season, you can always put systems in place to help you get ready for next year.
Here are a few things to keep in mind, no matter what your situation is right now.
Know Where You Pay Taxes
First of all, it’s a good idea to know where you pay taxes. You might be paying taxes, even if you aren’t aware of it. Understand where you might be taxed.
Most of us think of federal income tax when we think of taxes, and that’s where we stop. However, most states collect income taxes as well. Don’t forget that you might be subject to taxes in more than one state, depending on your situation. When I moved across the country in the summer 2014, I realized that my husband and I were going to have to pay income taxes in two different states. Pay attention to those types of arrangements so that you understand where you might have to pay taxes.
You should also think of other taxes that you pay. You pay payroll taxes on a certain amount of your income. If you are working for someone else, the payroll taxes are usually taken out automatically, and your employer pays some of them. However, if you are self-employed, you will need to pay both ends of it with the self-employment tax. It’s important to understand how self-employment tax works, and how you might need to pay it.
You should also understand whether or not you should be paying quarterly taxes. If you have any self-employed income, there is a good chance that you should be making quarterly estimated payments. Otherwise, the IRS can come after you, and maybe even charge you interest and penalties. Some states also require quarterly tax payments. My old state of residence didn’t require quarterly payments, but my new state does require quarterly payments, so that will change the way I do things.
Finally, it can help to understand your property taxes and sales taxes. Not all states charge these taxes, but you should know when you pay them, and how they are paid. In some cases, you might pay property taxes monthly, and have the amount held in an escrow account. Then, when the bill is paid, the account is used. In other cases, you might need to make a payment all at once. Knowing how it works allows you to plan ahead so that you aren’t caught with a big bill that you can’t afford.
What’s Your Marginal Tax Bracket?
The next item to understand is your marginal tax bracket. When you pay taxes, your bill is based on your marginal tax bracket. You should understand how this works, since it can help you in your long-term tax planning.
A marginal tax bracket is the bracket in which you pay taxes on the last dollar you earn. This means that the bracket you are in doesn’t reflect your total percentage of income paid in taxes. Someone in the 25% bracket isn’t paying 25% of their income in taxes. Instead, you pay according to what you make in each bracket. Let’s say you file jointly and your taxable income (after all your deductions and exemptions) is $75,000 a year for 2015. You are in the 25% tax bracket, but you aren’t actually going to pay $18,750 in taxes. Instead, all of your dollars will be taxed in the appropriate bracket. So, first of all, the money you make up to $18,450 will be taxed in the 10% bracket. Then, in the 15% bracket, you will be taxed on the amount you make between $18,541 and $74,900. The money that will be taxed at 25% is the money between the $74,901 and the $75,000 that you make. You’re only going to pay 25% on $99.
Each year, the IRS adjusts the tax brackets to reflect inflation. You should also be aware of the possibility that you might fall afoul of the Alternative Minimum Tax, or AMT. Pay attention to where you fall, since you don’t want to find yourself stuck with penalties for not paying enough.
You should also understand how your marginal tax rate is different from your effective tax rate. Your effective tax rate is the actual percentage of your income you wind up paying in taxes once you figure out what type of income you have. For example, someone with a lot of long-term investment income or dividend income might be in a lower tax bracket, since that income is taxed at rates more favorable than income earned through wages. Your effective tax rate might also include what you pay in state taxes, as well as payroll taxes (once you reach a certain threshold, your payroll taxes are capped, so you don’t pay more, even if you earn more). As a result of these realities, your effective tax rate might be smaller than you thought. There’s a reason that Mitt Romney famously has a lower effective tax rate than many middle class Americans. (Of course, in sheer numbers, Romney pays more. But the percentage of his income that he pays in taxes is a different story.)
Once you understand how your marginal tax rate works, and how it relates to your effective tax rate, you can make tweaks to your financial plan so that you take advantage of this.
Deductions and Phaseouts
Now that you have a general idea of where you stand, it’s time to figure out what types of tax deductions you are eligible for. These tax deductions are helpful because they lower your taxable income.
If you have enough deductions, you can move to a lower tax bracket. Look at different deductions you might be able to take. In some cases, it’s possible to qualify for previous year tax deductions if you are savvy about the way you make your last minute tax deductions. Even if you can’t deduct something for the previous year, you can still plan ahead. If you want to make the most of your deductions, plan your tax-advantaged spending early on and follow the plan. That way, you won’t miss deductions (and leave money on the table). It also helps because you can spread out the cost of your deductions in your spending plan throughout the year. Your charitable donations can be spread out to be more manageable, rather than straining your budget in December with one big check.
Planning ahead can also help you work around phaseouts. There are some deductions that come with phaseouts as your income rises. Student loan interest and mortgage interest deductions are examples. If you want to avoid the phaseouts, you can plan a strategy throughout the year to use business expenses, charitable donations, retirement account donations, and other deductions to your benefit. That way, when the time comes, you are more eligible for the deductions you want to take.
Don’t forget, too, that your deductions can impact what other taxes you pay. The Patient Protection and Affordable Care Act (PPACA, also called Obamacare) does more than require you to buy health insurance or pay a penalty. For those with certain incomes, there are also additional taxes built in. A Medicare tax and an investment surtax are included when you meet certain income thresholds. The right planning with your deductions can help you avoid some of these taxes, or at least reduce what you owe. This is something to consider as you move forward and plan your tax-advantaged spending for the year.
Organization and Record Keeping
Finally, make sure you are properly organized and you keep good records. This streamlines the whole process. One of the best ways to make sure that you are on top of your taxes is to hire an accountant as your taxes become more complex. After doing my own taxes for years, I finally began working with an accountant because it was taking up too much of my time to do my own taxes. An accountant helps me stay organized, and if there is an audit, my accountant will take care of representing me.
Of course, even if you do have an accountant, that doesn’t let you off the hook when it comes to record keeping. You are still responsible to provide the documentation for your tax return, and you need to be able to back up your claims in the event of an audit. I like to stay organized year round with a file for my tax documents. Then, when it’s time to prepare my return, everything is ready for the accountant. I don’t have to hunt for paperwork, and I am less likely to forget something important.
With the right planning and organization, it’s possible for you stay ahead on your taxes, and ensure that you only pay what you absolutely have to.