Part one of Wealth Club's tax time primer: How to put yourself in a position to succeed, or at least get a refund.
My parents dropped the horrible bombshell that they’re not going to be doing my taxes this year unless I have the money to pay the accountant. I’m tempted to do so since I think I’ll be getting a refund anyway, but I’m not completely sure. I want to attempt to do my own taxes, but I’m really not interested in messing up and having to go through a whole ordeal.
Sigh, if only we could be dependents forever. Whether it’s your first time, you’ve been bumbling through for years, or you just pass everything to an accountant, adults need to pay the public piper his due once a year—and you shouldn’t wait until April. This week I’ll talk about what you can do to put yourself in the best position to succeed before tax time; next week we’ll talk about how to get the job done.
Trying to thoroughly answer the question "How do I do my taxes?" is a monumental task, and certainly not one that I’m inclined or qualified to perform. I’m not an accountant. What I’m going to do is put the pieces together and define some basic tax terms for you. The IRS.gov website is quite thorough and I’ll be linking frequently to various forms and pages that come directly from the IRS. Here’s your first stop in navigating IRS.gov for the individual taxpayer. Buckle up, it’s a wild ride.
[Ed. Note: After accidentally committing tax fraud—thanks for getting me out of that one, Mike!—I found my many interactions with IRS customer service uniformly pleasant and helpful.]
For most people, the tax liability experience begins with your W-4 form—formally known as the Employee’s Withholding Allowance Certificate. You fill this form out when you start a new job—unless you’re a contract employee, more on that later—and employers must file a form from every employee with the Social Security Administration. It tells the government your marital status and the number of allowances you plan on taking when you file your taxes.
What’s an allowance? It’s the government’s way of allowing you, through your employer, to reduce the amount of money withheld from your paycheck. It’s based mainly on the number of people you’re responsible for; the first, most obvious allowance is yourself. If you’re single, childless and no one else will be claiming you as a dependent, this most likely will be your first and only allowance. Since a single person making $40,000 doesn’t—and shouldn’t—owe the same amount as someone making $40,000 and supporting a family of four, the W-4 is a way for people to more closely align their withholding to what they will eventually owe in taxes.
The more allowances you take, the less money your employer will withhold. It’s worth noting that any tax breaks you plan to use can be thought of as an allowance. Maybe you’re anticipating a large tax credit—for example the Lifetime Learning Credit, a refundable tax credit of up to $2,000 depending on how much you paid for higher education expenses. This would substantially change the amount that should be withheld from each paycheck. But your employer may not know this, and it doesn’t exactly fit into any of the rows on the W-4. That’s why you have the option of telling your employer to withhold any additional amount you want. The IRS Withholding Calculator is a handy tool to help you figure out what to choose.
At the end of the day, remember this: You’ll receive a tax refund when your employer has withheld too much in taxes, and you get a tax bill when they’ve withheld too little. In a perfect world, everyone would choose to withhold the exact amount they’ll have to pay in taxes. But people don’t know what their tax bill is going to be in advance, and many people choose to have an amount withheld that won’t be close to what they owe.
Personally, I choose to take zero allowances on my W-4. This tells my employer to take out the maximum amount of taxes for my salary. I would rather have smaller paychecks, and essentially guarantee that I’ll get a refund, not a bill, when tax time comes. I’m basically giving the government an interest free loan—they hold onto my money until I get a refund when I file. Although technically inefficient, I don’t care. I know my spending habits enough to know that if I had an extra few dollars every two weeks, it would be spent on trivial things, and that in the post-holiday season, when Uncle Sam rears his ugly mug, I will probably have a credit card bill slightly higher than I would like. Receiving a refund softens the blow.
If you’re unsure how your W-4 reads, ask your employer. They’ll have it on file. If you’re unhappy with what you see, change it. You’re legally entitled to submit a new W-4 at any time, and your employer must submit the changes.
In the event that you’re a contract employee, instead of filling out a W-4, you may fill out a W-9, the Request for Taxpayer Identification Number and Certification form. This allows you to get paid; however your employer may not be withholding taxes from your gross pay. You’ll need to keep track of how much you made in 2011, and will eventually need to add this to your total Wages when it comes time to file. If this contract work is a second job, and you’re first job does give you a W-4, it may not be a bad idea to lower your number of allowances, in anticipation of the fact that you’ll need to owe taxes on the contract work.
Now on to the other end of the rainbow—what happens when you have to actually pay your taxes.
At the start of a new year (right about now) your employer will send you a W-2 form for the previous year (2011)—this is your Wage and Tax Statement. It states the total amount your employer paid you, as well as the various line items that turned your total pay into your net, or take-home pay. These include required items such as federal/state/local tax withholdings, Social Security and Medicare taxes and other electable items, such as pre-tax retirement plans, flexible spending account payments and health insurance deductions.
You’ll most likely be given a few W-2s per each job. This allows you to send them to your grandparents so they can proudly display them on their refrigerators…nope. You may need more than one to file at the federal, state and possibly local levels. In the days when people actually sent in their taxes via regular mail (some people still do, and that’s fine) you had to send in one of these wallet-sized versions. But if you’re doing your taxes yourself, I recommend an electronic filing service like TurboTax, TaxACT, H&R Block, where you can import the data on the W-2 directly into the software.
These online services can be very useful for anyone with a relatively simple tax situation—you’re filing largely based on wages for a few jobs, not complex investments, and you’re not planning a raft of special deductions. You’ll most likely going to have to pay at least a little for the service—the state return is rarely free, but it could very well be worth it, especially if this column gave you the chills.
Not only do these services take some of the pressure off you, they are a great way to stay organized from year to year. It’s easy to forget how it all works after a year away from tax world, so keep a copy of your returns for every previous year. They may very well be your best resource in figuring how to untangle 2011’s tax web.
Next time we’ll get our hands a little dirtier and I’ll discuss a bit more of the math behind the scenes, and how to make that math work in your tax favor. Gather your papers, kids.