How Tax Withholding Affects Your Tax Refund

Every year, around March and April, we begin to hear people talk about the big plans they have to spend their anticipated tax refund. Some plan vacations to various destinations around the world, others plan to pay off debt, or add to their savings. All too often, this anticipated windfall turns into an unwelcomed tax bill to the IRS.

We have found that many individuals may not know what goes into calculating their yearly income taxes and why they may or may not get a tax refund. This article will serve as a simple reminder of the fundamental components that determine your tax refund.

What are Tax Refunds?

Tax refunds are not gifts from the government that you receive for filing your taxes. They are a return of your dollars that you have overpaid in taxes during the year. In most cases, when you receive some form of taxable income whether it be from a pension, Social Security, or a distribution from a retirement account, a portion of your payment goes directly to the IRS, or toward paying your state income taxes. This is known as withholding. You, the taxpayer, controls how much of your payment goes towards paying the IRS and the state. Due to tax deductions, tax credits, or a miscalculation, a household may over or under withhold the required yearly income tax they owe. An over payment of taxes will result in a tax refund, and an under payment will result in owing a tax liability. So, you, not the IRS or your state government, decide whether you get a refund each year because you determine how much is withheld from each paycheck.

The amount of your tax refund or liability received at the end of the year is not a good indication of your total yearly income tax liability. For example, a large refund does not mean your taxes are low, and having to write a check to pay state and federal tax does not mean your taxes are high. Receiving a refund or paying a liability is a reconciling of the income tax dollars you are required to pay.

Tax Withholding

Tax withholding can be adjusted on income from Social Security, pensions, distributions from IRAs, and salaries. You can also make an estimated quarterly payment directly from your checking account. So, if a person is looking for a large tax refund, they should increase the amount of taxes that are withheld throughout the year and the IRS will return it to them in the form of a refund.

Does it Matter if I Over-withhold or Under-withhold?

In most cases, the goal is to withhold taxes in the amount that will result in as small of a refund, or tax liability as possible. However, incomes, salaries, and laws can all change throughout the year making it difficult to achieve the goal of a net zero tax refund or tax liability. So, is it better to overpay taxes during the year and get a refund? The answer… it depends. It comes down to preference. Individuals who prefer to receive a tax refund check during tax season should look to over-withhold. Individuals who prefer to have extra cash throughout the year, even if that means paying a tax bill come tax time may prefer to under-withhold.

There are two extremes that help explain the concept of withholding and tax refunds.

  • Under-withholding: A couple has a taxable income of $81,050 in 2022 and withholds nothing. Their paychecks will be higher throughout the year, but when they file their taxes, assuming no penalty applies, they will owe a federal tax bill of $9,315.
  • Over-withholding: A couple has the same taxable income of $81,050 in 2022 and withholds $14,315. Their paychecks throughout the year will be lower since a higher portion is going to tax withholding. Instead of owing $9,315 at the end of the year, they will receive a refund of $5,000 because they over withheld.

It is important to understand that, assuming no under-withholding penalty applies, over or under-withholding taxes throughout the year does not result in a larger or smaller total tax liability. The only difference is the timing of when the taxes are paid.

When do Underpayment Penalties Apply?

You may be thinking, “Well if the timing of my tax payments doesn’t impact the amount of total tax I pay, then I won’t withhold anything all year and invest the tax payments in a high yield investment account. I can then pay my full tax bill at the end of the year and keep the interest I earn.” This can be a reasonable strategy assuming two things. First, you don’t lose money in your investment over the course of the year, and second, you don’t pay more in underpayment penalties than you make in interest. In most cases, you can avoid an under-withholding penalty if you withhold at least 90% of the tax due for the current year, or if you withhold 100% of the previous year’s tax liability.

You Owe What You Owe

Whether you are looking for a tax refund, or you prefer to not give the government an interest free loan and plan on paying your tax liability every April, you can rest assured knowing that as long as you satisfy the minimum withholding requirements, your total tax obligation will be the same.

The SECURE ACT: Tax Law Changes for IRA’s that Impact Retirees

As 2019 came to a close, the president signed into law a sweeping series of changes that will affect how we save for retirement as well as the distribution of IRA proceeds. The new law is officially entitled the Setting Every Community Up for Retirement Enhancement Act, but it is more commonly known as the SECURE Act. This new law includes both welcome changes as well as some controversial elements. As I said, the changes brought about by the SECURE Act were sweeping, but I am only going to highlight those changes that impact the retiree.

First, let’s address the more controversial parts of the law. There is a change to the rules that govern inherited IRAs, or so-called stretch IRAs.

Stretch IRAs

Previously, if you inherited an IRA, you were allowed to take distributions from the retirement account over your life expectancy. That is to say, a healthy 40-year-old person who inherited an IRA from their parents or grandparents could withdraw the funds over several decades.

While there are exceptions for spouses, minor children (until they reach the age of majority), disabled individuals, the chronically ill, and those within 10 years of age of the decedent, the new law requires that you withdraw the assets from an inherited IRA account within 10 years if the decedent passed away after December 31, 2019. There are no changes to inherited IRA accounts for those who died prior to 2020.

In the past, we have commonly recommended that an IRA participant’s spouse be listed as the primary beneficiary and the children be listed as secondary beneficiaries (not the family trust). This, most likely, may still be your best option, but the new law makes listing the children individually as beneficiaries less tax advantageous than before the new tax law went into effect. We look forward to discussing alternatives with you to make sure your family has the right beneficiary designation going forward.

Long Overdue Changes:

While the law governing stretch IRAs is creating challenges, there are also big, positive changes that we believe are long overdue.

  1. If you turned 70½ after January 1, 2020, the initial required minimum distribution (RMD) for a traditional IRA is being raised from 70½ to 72. Those who turned 70½ prior to January 1, 2020, are still required to take RMDs based on the old rules.
  2. You may now contribute to a traditional IRA past the age of 70½, if you are working and have earned income. Previously you were unable to make IRA contributions past age 70½.
  3. Many of you donate to charity directly from an IRA by making a Qualified Charitable Contribution (QCD). Now, even though some of you will not have RMDs until age 72, you are still able to donate to your charities using a QCD starting at age 70½.

Hopefully, this sheds some light on the parts of the SECURE Act that most likely apply to your situation. We appreciate the trust you have placed in us and we look forward to answering any additional questions that you might have.

Peterson Wealth Advisors has taken the academically brilliant idea of time segmentation and transformed it into a practical model of investment management that we call “The Perennial Income Model™”. To get a better understanding of the Perennial Income Model™ you can request our book “Plan on Living, a Retirees Guide to Lasting Income and Enduring Wealth”. For specifics on how the Perennial income Model™ could be applied to your retirement income plan, schedule a complimentary consultation with one of our Certified Financial Planner™ professionals

Scott M. Peterson is the founder and principal investment advisor of Peterson Wealth Advisors. Scott has specialized in financial management for retirees for over 30 years. Scott is a regular presenter at BYU’s Education Week and speaks often at other seminars regarding financial decision making at retirement. He also literally wrote the book on retirement income, Plan on Living: The Retiree’s Guide to Lasting Income & Enduring Wealth. 

How the CARES Act Impacts Retirees

We are all on information overload these days, so I am trying to only share information with you that is pertinent and that directly impacts your situation as a retiree.

Our government sprang into action this past week to create an unprecedented stimulus package to combat the financial effects of the coronavirus. The new law resulting from this stimulus is called the Coronavirus Aid, Relief, & Economic Security Act or the CARES Act. The CARES Act covers a lot and it contains provisions that are designed to benefit individuals as well as businesses. I think it is important for you to understand some of the major provisions of this new law but the following is not intended to be an all-encompassing review of the CARES Act. I simply want to outline those provisions of the stimulus package that most impact retirees.

  1. Eligible taxpayers will receive a tax rebate check. The amount of the tax rebate is $1,200 per person plus $500 per dependent child. The amount of the check is reduced by a phaseout provision for individuals who made over $75,000 and couples that made over $150,000 last year, or in 2018 if you have not filed your 2019 taxes. Starting in May, you should begin to see this money deposited in the checking account that receives your tax refund or into the account where your Social Security check is deposited. If the government has no checking account on file for you, you will receive a check in the mail. Please be careful of scams! Nobody from the government will be calling or emailing you regarding this rebate!
  2. Many retirees begrudgingly take money that they don’t need out of their IRAs once they are age 72 (previously was age 70.5) because the required minimum distribution rules stipulate that they such a distribution. The CARES Act has eliminated the IRA required minimum distribution requirements in 2020. Retirees who have taken required minimum distributions within the last sixty days can redeposit their RMD to eliminate the tax on those distributions. For retirees who donate to charity: It can still be advantageous to make charitable contributions directly from your IRA to your charity even though there is not a required minimum distribution obligation in 2020.
  3. The tax filing deadline has been extended from April 15th to July 15th. This means that the date to make 2019 contributions to IRA and HSA accounts has also been extended to July 15th.

There are additional provisions and benefits associated with the CARES Act for those that have contracted the virus, have a spouse that has contracted the virus, or if you have lost your job as a result of the coronavirus. I won’t mention those benefits here but you should be aware that they exist if you are unfortunate enough to fall into this category.

Please contact us if you would like specifics or have any questions.

 

Strategic Opportunities in a Market Decline

“A pessimist sees the difficulty in every opportunity; an optimist sees the opportunity in every difficulty.” – Winston Churchill

As I watch the emotional reaction of investors during market turbulence, I concur with Churchill as I see individual investors categorize themselves into two separate camps. They are either victims or they are opportunists.

Beyond reminding the self-prescribed investment victim of the overwhelming historical evidence of the resiliency of the stock market, there is little that can be done to save them from themselves as they panic and sell as markets decline. Therefore, let’s not waste our time discussing how to rescue the lemmings as they throw themselves off a cliff

Let us focus instead on the positive steps that can be taken by an investment opportunist when stock markets retreat. There is so much that can and should be done in every financial crisis. The prepared opportunist can turn today’s temporary stock market lemon into tomorrow’s lemonade.

An investment opportunist recognizes that every downturn is temporary, every bear market is eventually followed by a bull market, and that the stock market will eventually go on to reach new record highs. There has never been an exception to this pattern, only the timing and duration of the bear and bull markets is uncertain.

Six ways to take advantage of a temporary market downturn:

1. Roth IRA Conversion

A traditional IRA will someday be taxed while a Roth IRA grows tax-free. Therefore, Roth IRAs are more advantageous to own than traditional IRAs. You can convert a traditional IRA to a Roth IRA, but you must pay income tax on the entire amount of the traditional IRA that you convert. So, let’s say you own 10,000 shares of ABC stock that are priced at $10 per share. The value of your investment is therefore $100,000. If you were to convert these 10,000 shares at the $10 price you would need to pay income tax on the $100,000 converted to a Roth IRA.

In a down market, an opportunist would realize that his ABC stock is now only worth $7 per share. If he were to convert all 10,000 of his shares that are now worth only $70,000, he would only have to pay tax on the $70,000 Roth conversion, not the full $100,000. When the price of ABC stock rebounds to $10 per share our optimists would have $100,000 worth of Roth IRA value but they would have paid tax on $70,000 worth of Roth IRA conversions.

2. Refinance Your Mortgage

When the stock market recedes, it is common for the Federal Government to step in and attempt to jump-start the economy. They do this is by reducing interest rates. This move will often temporarily reduce mortgage interest rates. The opportunist would jump at the chance to refinance their mortgage because a thirty-year, $300,000 mortgage with a 3.5% interest rate costs $60,000 less over thirty years than the same mortgage with a 4.5% interest rate.

3. Fund IRA/Increase 401(k) Contributions

An easy way to take advantage of a temporary market downturn is to contribute additional funds to retirement accounts. We have all heard the maxim, “buy low, sell high”. Well, then buy when equities are selling at a discount.

Some of you will remember the years 2000-2009 which was the worst decade for investing since the great depression. Large stocks ended the decade at the same levels that they began the decade. That’s right, ten years with zero growth. The pessimist would say, “I am glad, or I wished, that I missed out on that disaster”. Meanwhile, for the opportunist, this decade was a wonderful investment opportunity! As markets went down the opportunist systematically purchased depleted equities in their 401(k)s and IRAs at a substantial discount. These once depleted shares are now worth 400% of their 2009 value and that’s taking into consideration the latest downturn.

Those who make annual contributions to retirement accounts should contribute when markets plummet. Those who systematically contribute to 401(k)s should consider reallocating conservative investments within their 401(k)s to equities and/or increasing their 401(k) contribution rates.

4. Rebalance Your Portfolio

There is proven value and additional security when investors diversify their investments. Few would argue that diversifying or creating the proper mix of investments to accomplish specific goals is important. The challenge is keeping portfolios diversified. As markets fluctuate, portfolios get out of alignment as top-performing investments become a bigger allocation and underperforming investments shrink to a lesser allocation of the original portfolio mix. Rebalancing brings the investments back to the original mix. The process of rebalancing requires buying and selling securities which ofttimes create unwanted taxable gains. Rebalancing can be accomplished during market downturns with greater tax efficiency because the capital gains incurred are less as depleted equities are sold.

If it so happens that your rebalancing requires purchasing equities to bring your portfolio back to its original composition, then rebalancing adds additional value as temporarily beaten up equities are purchased at discounts.

5. Tax Loss Harvesting

Let’s say that Clara bought a mutual fund three months ago for $100,000. Because of the recent slide in equities, this investment is now only worth $80,000. Clara could simply hold on to that investment and wait for it to rebound to $100,000. There would not be any tax benefits or consequences by waiting for the depleted shares to rebound.

However, Clara is an opportunist and hates paying income taxes. She decides to sell the diminished investment and create a $20,000 capital loss which would benefit her taxwise. She then invests the $80,000 into a very similar investment to that which she sold and when the market rebounds she would still have the $100,000 of value plus a $20,000 capital loss that could save her several thousand dollars in income taxes.

6. Invest Excess Cash

The most important criteria to consider when deciding how to invest is time horizon, or how long money can be invested until it is needed. Money that will be required in the next five years for a purchase or for income should not be invested in equities because of the short-term volatility that accompanies the stock market. Money needed between five to ten years should be moderately invested into a mix of equities and fixed-income investments. Money that will not be needed for ten years and beyond should be invested in equities to help fight inflation. Market corrections provide opportunities to reassess portfolios and put money that is on the sidelines to work.

A Concluding Thought:

The richest men in the world, from every generation, did not get that way by betting against the ingenuity and indomitable spirit of the human race to create a better life for itself. Successful investors have always been richly rewarded for their willingness to invest in the future. This generation is no exception. Today’s optimists, or those willing to invest a better tomorrow, are thriving.

3 strategies to deal with you RSU tax bomb

An old friend of mine works for a technology company in Utah. The company was recently acquired, and he will receive $1,000,000 from the company’s Restricted Stock Unit Plan. He is already in a high tax bracket from his regular income and his RSU payout will only compound his tax problems. He stands to lose between 40-45% of his RSU payment to taxes!

So how does one deal with the RSU payment tax bomb?

A little bit of proactive tax planning can go a long way to help you keep more of your RSU benefit now and help you secure your future.

3 strategies for reducing the tax hit from your RSU payment:

1. Max out your 401k contributions. This idea is simple, so simple in fact that many people will probably overlook it. For 2019 you can contribute $19,000 on a pre-tax basis, and an extra $6,000 on top of that if you are over age 50. If you are not on track to max out your 401k, talk with your HR department to make the switch. In the year you receive your RSU payment, you will want to make sure that your 401k contributions are happening on a pre-tax basis. Roth 401k contributions may have made sense in past years, but it will not be your best option in the year of an RSU payment.

2. Fund a 529 education account for each of your children. Utah offers a 5% tax credit for contributions up to $4,000 per qualified beneficiary. This means you can get a $200 tax credit for each child. With a 529 account, you are not only reducing your taxes this year, but all the growth is also tax free and will be tax free when it is taken out to pay for college down the road.

3. Pre-pay multiple years of charitable donations. This is the most powerful tax reduction strategy available through the use of a Donor Advised Fund. A donor advised fund, or DAF for short, is like a charitable investment account that holds your charitable dollars until you ultimately decide where you want those charitable dollars to go. The value of the DAF is that you will receive a tax deduction in the year when you need it most and the money you donate to the DAF can then be parsed out in future years to pay church donations or to support other charitable causes in the community. The funds can even be used to pay for the missions of your children and even grandchildren! Another unique benefit of a donor advised fund is that the money that is placed in the fund can be invested. This means your initial contribution to the DAF can potentially grow to enhance the future value of your contribution to your charities.

One last piece of advice: buying a product is not the solution, having a plan is. There are plenty of salesman who are eager to earn a commission by selling you a product, but what you really need is a plan. At Peterson Wealth Advisors we have been helping successful professionals and retirees with complex financial planning decisions since 1986. Click here to learn more and schedule a complimentary consultation to review your situation with one of our experienced advisors!