Phil: Welcome to Tull Financial, Financial Friday where we give you a quick tip on a topic that has to do with financial planning services. Today’s topic is the fun topic, the great topic everyone loves—tax planning! Drew Overton here with me heads up a lot of our tax planning strategies in our office and works with our clients on those. I know we’re right around tax filing time, so give us an update.
Drew: Yeah, so for individuals, the tax filing deadline, as hopefully most of you know, has been pushed back to May 17th and so we’re in that window now where if it was a normal year, you’d be late but thankfully it gives us a little breathing room. If you haven’t filed it yet, go ahead and get to that.
But as Phil said, today we’re going to talk about withholdings and I want to back up first and say you know, what are withholdings? There are really two ways for taxes to be withheld and that is for W2 employees where your employer is required to withhold that from your paycheck.
You can withhold that throughout the year and they pay that to the IRS quarterly. But you might also say, hey I’m not withholding enough, and I need to pay estimated taxes. For most self-employed people they’re pretty used to making those quarterly payments throughout the year. So those are the two ways.
Generally, you’re earning income throughout the year, you’re taxed on that income throughout the year but we want to make sure that those withholdings reflect what your liability is and we’ll get to that later as far as certain penalties that you may owe under withholding.
Phil: Withholdings I know is kind of this big, vague thing that a lot of people just do when they sign on with an employer. You go through your W2, you mark off how many dependents you have and you call it a day. So how does that—you marking off how many dependents we have or head of household—impact from a 1,000-foot view?
Drew: So, what you’re basically trying to do is say you know how many deductions you have and how that will impact your tax liability, which would then be reflected in your tax withholdings. When you’re going through those forms with your employer and you’re doing all those forms that are boring, you’re actually trying to nail down and say what’s the exact amount of taxes I need to withhold?
This includes that W4 form which we will get to later. But the number one thing I think that we need to be aware of is there is a penalty to an underpayment. So, if you’re not withholding enough and you get to April 15th, or May 17th for this year, and they say hey you didn’t withhold enough, there is a penalty for that.
To dive in a little bit, you need to withhold at least 90% of the current year tax liability or 100% of last year’s, whichever is less. For the 100% number for last year, of course if you have other income or if you have more income, that’ll be adjusted to 110%. The number one rule or number one thing is you don’t pay the underpayment penalty. Make sure you’re withholding enough in your paychecks so you can avoid that.
Phil: We were even talking about that just before this. We were on both sides of it where you were owing and I was getting some money back on mine. One hurts, one feels good. But actually, neither one is really truly what you want and what we’re going for here right?
Drew: That’s right. That’s another thing everybody deals with, and as Phil said, I owed a little bit and he got some back. Let’s start out with me owing a little bit. It hit me it was a decent tax bill and you know it put a little cash strain on us for a little bit, and that’s why we advise people to have those emergency funds in case of things like that.
So that hurt a little bit, but then on the flip side we were talking about how when people see that money hit their bank account when you get a tax refund, some people think, hey the government paid me money—I’ve got more in my bank and I’m feeling good. But actually, what you did was you over-withheld and so you gave the government that interest-free loan. I know rates are low right now but it’s hard to get a loan from a bank for 0% interest.
Phil: Exactly. So, that’s something you want to avoid. Another thing we were talking about earlier was the opportunity cost of not investing that money.
Drew: Exactly, and so the market went on a tear last year. If you over-withheld, the government was using that money and you weren’t able to invest that in the market. These are things we think about when you set your withholding. The ideal withholding would be net zero so you don’t owe anything. You don’t get a refund back. Granted that’s very hard to do. It’s very hard to perfectly estimate your taxes during the year. But we say if anything maybe owe just a little bit.
Phil: Yes, you’re not giving that interest-free loan to the government. I mean for me, like you said, this was a painful one, it was painful for me knowing what the market did over the past year and I could have been putting that in the market and investing it, things like that. There’s an opportunity cost there. How do we implement that, how do we move forward and put these lessons into practice and what time of year do we have to do it? At the beginning of the year?
Drew: There’s a really good tool on the IRS website, it’s their tax withholding calculator and what it does is it walks you through how to project your tax liability for the current year, so make sure you have your paycheck in your hand.
It’s going to ask you some specific questions such as do you have a job? Does your wife have a job? How much are you guys withholding? How much do you earn? It kind of walks you through the deductions as well. It assumes you’re taking the standard deduction and so there’s some intricacies in there, but it does walk you through it really well.
Once it gets you to the end it basically compares your tax liability and estimate and how much have you been withholding and from there they tell you the difference and they say, hey you either need to withhold more or less and it gives you instructions on the W-4 form, which is what we’ll talk about next. It walks you through and says here’s what sections you need to fill out to make sure that you’re not paying a ton at the end or losing out on your money throughout the year.
It’s definitely a great tool online to take advantage of. There are a couple of things to note on that W-4 form as far as if you have interest or dividends or capital gains or other things, other unearned income where you’re not able to withhold. You can plug those things in, plug in your deductions. It really does get granular but it’s all for your benefit. It’s trying to make sure that you’re not withholding more or less than you should be.
Phil: That’s great. And another point is you can do that any point during the year. I know we’re in April right now but you can still do it now or you can do it later on this year. One thing you alluded to is different life changes can happen throughout the year so even if you set it (withholdings) one time, that may not fit you later on in the year.
You can tweak that later on whether you lost a job or maybe your spouse got a job and now you need to account for that as well as additional capital gains and investments and things like that. There’s a lot that plays into that so utilize that calculator, utilize tax preparers. I know a lot of people are doing TurboTax and H&R block all these different online tax planning resources, so utilize those.
I know they have tax professionals that you can call within those different platforms. Use your financial planning services advisors for projecting out, really looking out, what can you expect from those capital gains maybe things like that and find other strategies. I know we talk about different strategies all the time. If you don’t have a financial planning services advisor, we would welcome the opportunity as well. Any last closing tips or thoughts Drew that you want to give to us?
Drew: You know Phil hit on a great point, you can change the form anytime, so for those of you looking right now go ahead and check it out. Now is a good time to check your withholdings especially if you already filed your tax return for 2020 and if you’re like us either over or underpaid, go ahead and make those adjustments now.
Then throughout the year if you have a baby, as he said, or if you buy a house or anything that’s going to change your tax liability, that should in turn be reflected in your withholdings so make sure you’re talking to your tax preparers and us. Just know there’s a lot to it but hopefully, we tried to boil it down for you and make it simple.