2008 Tax Season

Yes, the 2007 tax season is behind us, officially completed for most folks on April 15, 2007, but it is never too early to plan for 2008. In fact, 4 months have already gone by this year, and with it 4 months of possibly the same mistakes made from last year.

Did you get a refund this year?

Maybe you have heard this before, but for those who haven't, there is no such thing as a refund from the government, unless you are a low income earner who qualifies for the Earned Income Credit (go to IRS.gov for more info on that). Any amount you received from the IRS this year or in years past is simply an overpayment of tax. Just go to the bottom of your 1040 and find the amount of your "refund"; you will see the word "overpayment" to the left.

Let me explain how the overpayment is calculated. Each year you earn income, then the IRS allows you a standard deduction or to itemize certain deductions like home mortgage interest and taxes, and exemptions for yourself, spouse and each dependent, and you're left with the taxable income. Then the IRS takes the taxable income and multiplies it by the marginal tax rate (check out IRS.gov for 2008 tax tables). To simplify things, marginal simply means that the income is broken down into brackets, where the first 7825 is taxed at 10%, then the next bracket at 15% up to the highest bracket of 35%. This system ensures that wealthy pay 35 cents on every dollar they earn over a certain amount, 349,700 in 2007. Once the tax is calculated, the amount is subtracted from the amount already withheld from your checks, along with certain credits you receive for raising children, saving for retirement, etc. If the amount withheld exceeds the amount you owed, you get a "refund".

Now ask yourselves my friends; if you were to borrow a 1000 from your local bank, and they could somehow suspend payments until the loan matured in say, one year, what are the odds that they will not require you to pay interest on the loan? My guess? Substantial interest is required. But when you give the government extra money each month in anticipation of your "refund", how much interest do you earn on your money? None!

Now, I don't think the IRS should give you interest. In fact, they are nice enough to allow you to pay in only 90% of what you owe each year with NO penalties! Did you know this? That means if your tax liability was 10,000, you would only have to withhold 9,000 from your checks each year, leaving you a 1000 balance the following April. Sounds like a lot to owe? Break it down into monthly installments, and you could simply put 80 dollars away each month (You were going have that withheld from your check remember?). Also, if you always receive a refund each year, calculate how much interest you could have earned, and may in the future. Simply take the refund, say 4000, an multiply by a reasonable return, say 8% in a long-term growth fund. That's 320 dollars of interest. Now take the balance of 4320 an multiply that by 8% and you have $345.60 of interest. That's the power of compound interest, which I will discuss in a later post.

Talk to your HR people now about adjusting your withholding, or a competent accountant (hint: I am one!)