Planning Is How You Beat The Tax Game

As the year begins to wind down and we approach the holidays, it is smart to take one last look at your financial situation and determine if anything can be done to lower your tax liability before December 31st. Most people don?t realize that in order to win the game of taxes, you have to plan throughout the year and take necessary actions before the following year when it is too late.

Many people have relatively simple tax situations and end up with a big refund each year. But as you may already know, getting that big refund each year is like flushing money down the toilet. Since the U.S. tax system is pay-as-you-go, what should you do when something happens during the year that has major tax implications that will result in you owing money? Uncle Sam will come knocking on your door demanding payment immediately. And he won?t care that for the last 10 years you?ve gotten refunds and this year was an exception.

Here are some unexpected situations that can lead to a big tax bill at the end of the year:

  • Winning a big prize (lottery, car, game show, etc...)

  • Court settlement

  • Big pay raise/bonus

  • Cancelled credit card debt

  • Getting a home makeover on a T.V. show

  • Early distribution from IRA or 401(k)

  • Divorce

  • Self-employed income

Depending on the amounts involved, the tax consequences can be quite significant and leave you in serious jeopardy. Here are a few actual situations that happened to clients I worked with (names have been changed). Sarah and Mark had $30,000 in credit card debt and had only been able to make the minimum payments each month. They made a deal with the bank to pay off $10,000 and the rest would be forgiven. In order to get that money, Sarah took it out of her IRA. This type of withdrawal carries a 10% penalty, which in this case is $1,000. Additionally, they owed taxes on the $20,000 cancellation of debt. They were in the 28% tax bracket, so this added $5,600 to their tax liability. Sarah and Mark were like most Americans and they normally received an average refund of approximately $3,000. After taking into account their new taxes, they now owed $3,600. Although this may be better than owing $30,000 to a credit card company, this $3,600 tax bill had to be paid immediately.

My second example is for the self-employed. Joe was an attorney who lost his job in 2009 and in 2010 decided to start his own law firm. Business was better than expected and he ended up making $35,000. Unfortunately for Joe, he never paid any taxes on any of his earnings. Unlike employees who have taxes taken out of every paycheck, the self-employed are responsible for sending quarterly payments directly to the IRS. Joe was in the 25% tax bracket and ended up owing almost $13,000 in taxes, plus penalties for owing so much!

Example 3: Steve made his first three quarterly payments of $5,000 in 2010. He believed that he qualified for the first time homebuyer credit of $8,000 and thought this could substitute for his fourth quarterly payment so he decided not to make his last payment. In the meantime, a company he owned 1,000 shares of stock in was purchased and he ended up making $50 per share.  That?s $50,000 profit that needs to be reported as income. When it was time to complete his taxes, he found out that stock transaction put him over a threshold and he didn?t qualify for the homebuyer credit. The stock transaction qualified as a long-term capital gain at a rate of 15%. Steve owed $7,500 for the stock trade plus $8,000 he should have made as an estimated payment for a total of $15,500.

All three of these examples, as well as the unexpected situations listed above, show the importance of planning for taxes before making any decisions, and since most of us don?t understand income taxes we should talk with a tax professional to make sure we are making an informed decision. When something major happens and you don?t account for it, you can get stuck with a very large tax bill at the end of the year. It might be better to think of taxes as a game we are all playing, because the best way to win any game is to plan ahead and make adjustments when necessary.

If you find yourself thinking that you need to hire a CPA or you are unsure, contact us for a free consultation and we can make sure you have all the information you need to help you determine if this is the right course for you. Share this article:

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Certified Public Accountants: What?s the difference?

Part One: How is a CPA different from an accountant or tax preparer?
In the world of accounting there are many different types of degrees, certifications and licenses. One of the most frequent questions I hear is, ?How does a CPA differ from an accountant or tax preparer?? There are big differences not only in training, but also in the services each one can provide. Read more ...

Part Two: What kinds of services can a CPA provide?
As discussed in part one of this article series, a CPA is a professional who has demonstrated an in-depth knowledge of financial accounting, tax, business law, auditing, and general business. There are four main types of services a CPA provides: Assurance, Accounting, Taxes, and Business Consulting. Read more ...

Part Three: Do I need a CPA? Many individuals and business owners often find themselves asking whether or not they should hire a CPA. For individuals this always seems to happen between February and April (tax time!). Business owners and/or managers may find this question creeping into their thoughts throughout the year as they deal with day-to-day operational finances, such as bookkeeping, payroll, and banking. When deciding if you need to hire a CPA, start by asking yourself the following five questions. Read more ...

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