So, You Filed Your Taxes…Now What?
Most of you probably know by now that the IRS has extended the 2020 individual tax deadline to May 17, 2021, due to the pandemic. However, several of my clients that got early starts have already filed their individual tax returns, with many more to follow now that a sole deadline remains. It is a huge relief to have your taxes filed and out of the way! But once you have filed your income taxes, what is the next step for you as a taxpayer?
Look at Your Return(s)
My hope is that my clients always review their returns carefully before they sign, and I always suggest that they do so when I provide the return for their review. However, I have no way of knowing how closely they look. With regard to an individual tax return, here is a big picture overview of some things that you might want to know about your taxes.
How Much Income Tax Did You Pay?
When most taxpayers look at a tax return, their biggest concern is how big their refund will be or how much they are going to owe to the IRS or their state department of revenue. But a more important question is “how much income tax did you pay?” Most taxpayers generally do not pay attention to their income tax liability for each year. They are happy to have the return filed and have taxes out of mind until they file their return next tax season. However, if you do not know how much tax you are paying, how do you know whether you are paying too much tax or whether you are paying too little? Yes, it is possible to pay too little taxes—and when you do—you are likely to be an audit target for the IRS and/or your state department of revenue. And the consideration that should follow is whether that is a fight that you would likely win if your return is in fact selected for audit.
What is Your Tax Bracket?
For federal taxes, in the United States, we have a “progressive tax system” meaning that the higher the level of your income, the higher the rate of tax is paid on that income. Some states also have a progressive tax system, others have a flat rate (i.e. the same rate for everyone across the board), and some states do not impose an income tax on individuals (but trust that these states make up for the revenue shortfall in other areas!). But your tax bracket is important to know because it determines how much you can save in tax by employing tax savings strategies. If you do not know your tax bracket, it is difficult to know whether it makes sense for you to choose a Traditional 401k over a Roth 401k or whether it makes sense to participate in certain employer-provided benefits that may be offered pre-tax. As self-employed, your tax bracket becomes even more important because as self-employed you have a greater ability to control your tax situation as you can partially base some of your business decisions on the tax consequences of those decisions.
What is Your Effective Tax Rate?
Given our progressive federal tax system, to estimate the amount of tax you pay across all of your taxable income, you need to know your effective tax rate. The effective tax rate is important because it helps you plan a good withholding amount or a ballpark percentage of income that you can set aside for estimated tax payments. It also provides a good litmus test for whether you feel you are paying too much or too little in taxes. If you are paying a small percentage of your income in taxes using legal means, reporting all of your income, and taking only allowable deductions and credits, that is perfectly fine. But in most cases with small business owners, in the absence of planning with a competent professional, if you are paying too little in taxes you are likely going to be a target for the IRS and state departments of revenue. Furthermore, if you do not have substantiation for your income and expenses, you could be facing a time-consuming and potentially expensive IRS examination with tax assessments (including penalties and interest) to follow.
Was Your Refund or Balance Due too Large?
As a general rule, with good planning, an individual should aim to pay as close as possible to his or her actual tax liability by January 15 following the tax year being filed. If you do not, you will likely have a large refund or a large balance due. While many people think that a large refund is a good outcome, it generally is not, given that those funds could have been used for the benefit of yourself, your family, or your business throughout the year. Alternatively, that money could have been used for investment purposes for which you will realize the returns rather than providing the IRS with an interest-free loan throughout the year.
Owing a large balance due is also not an optimal situation. A large balance due can result in an assessment of underpayment-of-estimated-tax penalty. Additionally, if the balance is not paid by Tax Day, then you will also owe a failure-to-pay penalty and interest as well. As a practical consideration, many people do not keep large sums laying around to pay unexpected tax liabilities. The funds are generally set aside for family purposes, business purposes, or investment purposes. So anything you can do to avoid a surprisingly large balance due will reduce your stress at tax time and also reduce potential penalties and interest.
What About Next Year?
Once you have analyzed your return to the best of your ability, you should aim to prepare yourself as well as possible for next year. Was the tax preparation process as smooth as you hoped? If not, maybe you can start earlier in the year or perhaps you can hire a bookkeeper or CPA to prepare or review your books periodically throughout the year.
If you feel that your tax liability is too large, consider whether it is worth it to you to try to reduce your tax liability by conducting some tax planning. Keep in mind that although your tax professional may provide planning services, that is generally not included within the tax return process. In fact, the tax return is oftentimes only a small first step toward what a comprehensive tax plan would entail. The more thoroughly your tax professional examines your individual and business’s financial situation, the more opportunity you will have to reduce your tax liability.
You may also want to reach out to your tax professional quarterly for assistance with estimated tax payments beyond “safe harbor” amounts, which are estimated tax payments based on last year’s taxes. While using the “safe harbor” for your estimated tax payments can prevent you from owing underpayment of estimated tax penalty, it will not prevent excessively large refunds or surprisingly large balances due.
If after reading this article, you feel that you would like to take an in-depth look at your tax situation in an effort to reduce your tax liability, I would be happy to assist you with a comprehensive tax plan! Feel free to contact me using the form below.