Don't Lend Money Interest-Free to Uncle Sam
By David and Erin Patterson
Everyone would rather receive a refund at tax time than have to pay additional taxes.
Receiving a refund, however, is equivalent to loaning your money, interest-free, to Uncle
Sam. With a little tax planning, you can avoid owing taxes when you file your return and
earn interest on the money you would otherwise have received as a refund.
For some people, receiving a refund is the only way they can save any money. Yet
many taxpayers spend the refund in a flash and still end up with no additional savings.
What might have been excess withholding or estimated tax payments that were too
large, can instead be directed to a savings or investment account throughout the year,
to earn interest and/or dividends.
If you're accustomed to refunds of $1,000 or more, the earnings can amount to enough
for a dinner out for two. Who deserves it more, you or Uncle Sam?
The key in tax planning is to pay the minimum amount necessary to avoid having to pay
a penalty. The Internal Revenue Service (IRS) provides two “safe harbors” for taxpayers
that, if met, protect you from a tax penalty, regardless of the actual taxes due.
The first safe harbor is achieved if your withholding and estimated tax payments (if any)
equal 100 percent of the previous year's taxes due. If your Adjusted Gross Income (AGI)
for the previous year was $150,000 or more, then this safe harbor requires that
payments equal or exceed 110 percent of the previous year's taxes due.
The second safe harbor is achieved if your withholding and estimated tax payments
equal or exceed 90 percent of the actual taxes due for the current year.
If your income has been pretty consistent, you expect no significant changes in income
in the coming year and your AGI was below $ 150,000, then 100 percent of previous
year's tax due is probably the best choice for a safe harbor.
If your AGI was over $150,000, or you expect significant changes in your income in the
coming year, then 90 percent of the actual taxes due in the coming year should be your
target for withholding and estimated taxes. In this case you will need to plan to set aside
the additional 10 percent over the course of the year so that it is readily available to pay
the taxes due. In the meantime, you can earn interest on the additional 10 percent set
aside.
Estimating your income in most cases is not that difficult if you earn only a salary. It can
be more involved for business owners or those who get bonuses, and they may need
help from their tax adviser.
Often the biggest problem comes from estimating distributions from mutual fund
investments in non-retirement accounts. However, since most mutual fund distributions
are made in the fourth quarter of the year, you can wait until early January to see what
the distributions actually are and then modify your 4th quarter tax estimate (due January
15th), accordingly.
The first year you do a tax plan will likely be the most difficult. We highly recommend that
you seek the advice of your tax accountant or financial adviser. After that, you may be
able to do your own plan.
Once complete, you can direct any excess amounts that would have been directed to
withholding or estimated tax payments to an investment account to accumulate earnings.
So the choice is yours - you can have a nice dinner out for two or let Uncle Sam have
more of your hard-earned money.
David C. Patterson, CFP® and Erin Patterson, CFP® are the owners of Patterson Advisors, LLC, a fee-
for-service-only financial advisory firm. Patterson Advisors, LLC is a Registered Investment Advisor,
registered with the State of Michigan, with offices in Waterford and Royal Oak, Michigan. Visit www.
pattersonadvisorsllc.com for more information.
Published in The Oakland Press OurTown Online Clarkston, April 2007
& in the Oakland Insider, August 2007