As tax day draws ever closer, you can practically feel the panic levels of millions of Americans rising across the country. It’s tax time. Every year, we prepare our tax returns, submit them and hope for a happy result. Usually our primary goal is to pay as little in taxes as legally possible. But that doesn’t need to be our only goal. What many people don’t realize is that our tax return contains a lot of helpful information, yet most accountants don’t take the time to help their clients decipher the fine print. Here are five areas where you may be able to save more money and plan better for the future.
If you owe the IRS little, or if get back very little money, you are doing it right. Large refunds seem nice in the moment because they are a way to help pay off bills or student loans, or splurge on something a little more extravagant, like a vacation. But the money is actually better off in your hands during the year, that way you can invest it or it can earn interest. Of course, these days the money won’t earn much in a savings account, but it is never a good idea to give up control of your money if you do not need to. So far the IRS has been very good about giving back your money in a timely fashion, but why leave anything up to chance.
Is your mortgage interest still a tax advantage? Most people with a mortgage on their primary residence itemize their deductions. Every year the mortgage is paid, the amount of interest is reduced. In the first years of a mortgage, the majority of the payment is interest, so the tax write-off is substantial. But as time goes by, more and more of the payment becomes the principal. At some point the mortgage is no longer helping your tax situation, but most tax preparers don’t mention this to their clients. If you have the money available in a low-interest account, it may make sense to pay off that mortgage. This is especially true if you have no plans to move in the next 5 years or more. Then the mortgage payment can be put toward your retirement savings, gaining in value, or if you are retired it could make you more comfortable now. Some of the happiest retirees I know are mortgage-free.
Are you maximizing your retirement plan contributions? Should you? Everyone should have money put aside for their retirement, but all of the plans and rules can be confusing. The first question is whether you contribute to a tax-deferred account like an IRA or a tax-free account like a Roth IRA. Which account you choose has to with whether you would prefer the tax deduction now—and the extra cash—or if you are one of those lucky people who anticipate retiring with a high income stream. The question to ask is: do you think you will be paying higher taxes in the future?
Some individuals with large tax-deferred retirement plans may not want to continue to contribute unless they have the option of a Roth 401k or another kind of tax-free plan. Otherwise, you are creating a tax time bomb that will go off when you hit age 70.5. That’s the age at which you must start taking a distribution (withdrawals) from your IRA whether you need the income or not. Large IRAs lead to large mandatory withdrawals. Every income earner should take advantage of company matches in their sponsored tax deferred plans and then fund tax-free accounts. However, those with lower incomes and no company plans may not benefit from a tax-deferred IRA, and would be better off with a tax-free Roth IRA. If we are only looking at taxes, the rule of thumb is that tax-free accounts should be funded first, then tax deferred, and finally tax-efficient accounts.
Do you have an HSA plan? If you have a high deductible health insurance plan you may be entitled to have a Health Savings Plan, and it’s generally a good idea to get one. The contributions to an HSA plan are tax-deductible; you can use the money to pay for medical expenses like copays, prescriptions, and other expenses not fully covered by your health insurance. Most people cannot itemize their medical expenses on their tax return, but the HSA is deductible. In effect, you get the deduction whether you itemize or not. And you can use an HSA like a savings account for when you do need the medical care. A single person under 55 can contribute $3,350; over age 55, $4,350. If you do not use the money, it can be removed for any reason without penalty at age 65 (otherwise it’s a 20% penalty). Make an HSA plan part of your emergency fund goal.
Are you currently using interest, dividends or capital gains distributions for income, as opposed to reinvesting them? If you are reinvesting them, you may be lowering your tax efficiency. People often complain that they must pay taxes on dividends and capital gains, even though they reinvested the money. This is true. It is not uncommon to see someone with over $10,000 in dividends—which they have not declared as income but is being taxed anyway—withdraw money from another account like an IRA, which is taxable. By doing this, you declare more income on your tax return than necessary. In these types of scenarios, you could reduce the amount you are withdrawing from your IRA and use dividends as income instead. The dividends are going to be taxed no matter how they are used. The money in the IRA can stay tax deferred a little longer. This will decrease your taxable income and overall taxes paid.
While in no way a complete list, the five steps outlined above are often missed, even by tax professionals. So while you should trust your accountant enough to prepare your return, don’t forget that our incredibly complicated tax system is complicated for everyone, including the people who get paid to navigate it. Never be afraid to ask questions—your bank account will thank you.