Monday, September 19, 2011

Financial FICTION #9: When you "break even" or receive a refund check from the IRS, you did not pay any income tax that year

Financial FICTION #9: When you file your taxes and break even or receive a refund check from the IRS, it means you did not pay any income tax that year. Alternatively, owing $500 means you paid just $500 in income tax that year.

This particular fiction is so prevalent that in all my years of consulting with people of all sorts, I don’t remember a situation where they didn’t give me a look of “you must be kidding” when I disagreed with their interpretation of how much they’d paid in taxes for a given year. As I have said all along, especially during this Financial Fiction series, when it comes to personal finance, most of what people have come to believe (and built their retirement livelihoods around) sadly enough amounts to little more than myth.

You see, just because you did not write a check to the IRS when you filed your tax return – or you received a refund – does not necessarily mean that you did not pay any income tax. Besides, in 99.99 percent of all cases, the amount you owed at the time of filing is not what you actually paid.

To explain this, I’m going to compress a typical tax return to just four lines you’ll find on every tax form (irrespective of which form you use to file):
  • Taxable Income
  • Tax
  • Refund
  • Amount Owed
Usually a portion of the paychecks (or if you’re already retired, your investment/pension income) that you receive throughout the year is withheld in anticipation of taxes due at the end of the year. Notice that these amounts are referred to as “withholdings” or “advanced payments.”

Come tax time, when you (or your tax preparer) fill out your tax return, this is what basically happens: Your “tax” for the year is calculated, based on your “taxable income.” Then, the amount of the “tax” you need to pay is compared against your withholdings (or advance payments). If your withholdings were more than your “tax,” you’ll receive the excess money back (a refund). On the other hand, if the opposite were true, you’d need to send a check for the difference – and you’d better sign and mail that check quickly.

Therefore, if you filed your taxes and broke even, in the sense that you didn’t have to pay anything extra, nor receive any refund, that only means that your “tax” amount for the year is equal to the amount you withheld in advance – it does not imply that you paid no tax that year. On the other hand, if you ended up having to send the IRS a check at tax time, that would mean that you were paying that amount in addition to what had already been withheld.

Just the other day, I met with a client who insisted that according to her CPA, she paid only about $800 in income tax as a result of the tax planning strategies/skills of the esteemed accountant. The problem, though, was that she’d paid a little over $7,600 in taxes last year. Of course, she at first thought I was probably not as competent as she would have preferred – because she insisted that she personally signed that $800 check and requested that I reexamine her tax returns, again! The difference? The client (and, interestingly enough, her CPA) were looking at line 76 of the Form 1040 which is the “Amount You Owe” line, instead of Line 44, the “tax” line.

Now, here’s a quick question for you: Would you rather know the total amount of tax you paid or just the difference you need to pay to top off what has already been withheld? The answer is a no-brainer, right? So the next time you examine your tax situation, please pay close attention and focus on the right line/box – remembering that there is a HUGE difference between “tax,” “refund,” and “amount owed.”

Contact a financial professional at Laser Financial Group to schedule your complimentary, no-obligation consultation to review your last income tax filing and learn how to maximize your retirement income. or 877.656.9111.

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