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Tax lessons learned for the 2013 season

Apr 17, 2014 @ 12:01 am

By Darla Mercado

Income tax, federal taxes, state taxes, IRS, renting, owning a home, having a child, W-4 forms
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I spent a good part of 2013 and early 2014 warning financial advisers about higher taxes that were just around the corner for their clients due to the American Taxpayer Relief Act of 2012.

But I never anticipated I'd be writing Uncle Sam a four-figure check. Ouch.

The exact amount on my husband and I owed for federal taxes was $4,175. That's decent-vacation-in-Europe money. Or new-pair-of-fancy-roadbikes money. The best alternative? We could've just left that money where it was originally: sitting in our emergency fund savings account.

For those of you who missed all the stories I wrote last year and through the first few months of 2014, here's a quick recap on ATRA: Single filers with taxable income over $400,000 and married-filing-jointly filers with taxable income over $450,000 will be subject to a top marginal income tax rate of 39.6%, plus a top marginal tax rate of 20% on long-term capital gains.

Starting at the $250,000 (single) and $300,000 (married, filing jointly) levels, there's also a phaseout of personal exemptions and itemized deductions. Don't forget the 3.8% surtax on net investment income, plus the 0.9% Medicare tax on wages, which apply at $200,000 income level for single filers and $250,000 for married filing jointly.

My husband and I do “well enough.” We're far enough from the $250,000 income threshold that we don't have to worry just yet about the additional levies on wages. We do earn enough, however, that we're close to the higher end of the 25% tax bracket.

But we did undergo a couple of major changes from the 2012 tax year to the 2013 tax year. The biggest one being that my husband was between jobs in 2012 and doing some independent contractor work on the side, then he became a W-2 employee for the full year of 2013. The end result? A huge bump in combined income for the two of us, raising us from five figures to the low six figures.

There are valuable life lessons to be learned here, for my husband and myself, as well as for your client base of moderately successful Gen X and Gen Y or Millennial clients who will one day hit those higher income levels.

Here are a few takeaways for advisers and accountants working with these younger clients. Don't be afraid to give these taxpayers a little homework:

1. Double-check your clients' W-4 forms. This is particularly important for households with two wage earners. Sometimes it's better to pay a little more in extra income taxes throughout the year, rather than having to write out one big check come April 15. A big mistake for these taxpayers is filling out the W-4 form — the form in which an employee calculates how much taxes an employer should withhold — in such a manner that the employee receives only the standard deduction and taxes are withheld in the 10% bracket. Sure enough, my husband and I have this on our to-do list, as we both withheld our taxes in the 10% bracket, underpaying on taxes through 2013. Updating a W-4 is a relatively simple fix that can save a bundle.

“What I recommend as a good fix in maybe 80% to 90% of situations is that one spouse should claim zero and married, while the other claims zero and single,” said Jerry Love, a certified public accountant and personal financial specialist.

When your Gen X and Gen Y clients' combined family income hits the $100,000 threshold, it's time to have a talk about Form W-4, updating it to ensure that they're withholding enough money in payroll taxes, Mr. Love said. “Once you get over $100,000, you can end up in the 25% bracket very quickly,” he added.

2. Freelancers, consultants and other independent contractors must make sure they're withholding enough taxes, too. Gen X and Gen Y clients with an entrepreneurial streak need to be aware that once they're on their own as a small business owner, they're responsible for ensuring they withhold and estimate the appropriate amount for taxes. “Many [independent contractors] came to the table to file, received this huge tax bill and didn't realize they had to withhold their taxes,” noted Ted Jenkin, co-CEO of oXYGen Financial. “More people in their 20s, 30s and 40s are doing small businesses and part-time work, generating multiple income streams. But they need to know how payroll, federal and state taxes work.”

3. Urge clients to step up their contributions into 401(k) and IRA plans. If it's available, kick money into a health savings account, too. Advisers with young clients: This might sound like a no-brainer, but you can't stress it enough. Remind your Gen X and Gen Y clients to throw in as much money as they can into their retirement savings plans. Sweeten the pot by telling them that they can cut their taxable income if they step up their 401(k) contributions. Personal note here: I'm contributing at about 10%, but my husband is contributing 5% of salary to his retirement plan. Yep, our CPA scolded us on this one.

A quick reminder of contribution limits in 2014: Workers can defer up to $17,500 into a 401(k), 403(b) and most 457 retirement plans, plus a catch-up contribution of $5,500 if they're 50 and up. Annual contributions to an IRA are capped at $5,500, plus a $1,000 catch-up contribution for those over 50.

A talk about budgeting goes hand-in-hand with encouragement to raise contributions. Gen X and Y-ers need to weigh the real-life implications of raising that 401(k) contribution. That'll likely mean cutting expenses elsewhere for the greater good of tax savings and retirement security.

4. Roth IRAs and Roth 401(k)s: Have a serious discussion about these savings vehicles, and be aware of the tax implications. Paying income taxes up front for saving in a Roth account might not be such a bad idea if your client's tax rate is low. Make sure your clients ask whether there's a Roth 401(k) available at work, too. “If your tax rate is at 15% or lower, you should probably do the Roth 401(k),” said Mr. Jenkin.

When it comes to looking at a conversion, make sure clients aren't running off and doing them solo. Ben Eisen of MarketWatch (a fellow Millennial) chronicles here his tax misadventures following a Roth IRA conversion.

“If you're doing this on your own, the conversion could bump you into a higher tax bracket,” said Mr. Jenkin. “But if your income goes down or if you have an off year, that's when you can look at converting those assets.”

5. Talk about owning versus renting. Time goes by quickly when you're young and having fun. In my case, my husband and I have been renting in the same building for four years. We like our neighborhood in Jersey City, N.J. Our CPA left us with this parting thought: If you're planning on staying in the area long-term, is it time to think about owning?

Take the time to crunch the numbers with your client: In a state with high property taxes, it's easy to let that sticker shock deter would-be homeowners from thinking about buying. Make a list of pros and cons for your Gen X or Gen Y-er, and think about the possible tax savings: Mortgage interest is tax deductible, as are property taxes. Fit that tax savings in context with the bigger picture of your client's finances: Is the purchase feasible? How much do you need to sock away for a down payment? Which expenses do you need to cut in order to get there?

But there are also traps. Make sure your estimated tax benefits are reasonable. “Don't overestimate the amount you'll get back if you purchase a home,” warned Eric Roberge, a financial planner with Beyond Your Hammock.

6. If your client has a child or is considering it, then it's time to have a talk. Kids cost money, but they come with other benefits, too: Now your Gen X or Gen Y-er can claim a dependent. Children bring a bevy of tax benefits, including the earned income tax credit ($3,304 in 2014 for one child of taxpayers filing jointly. This goes up to $5,460 for two kids and $6,143 for three or more). There's the dependency exemption of $3,950 for 2014. Further, contributions to Section 529 college savings plans can be tax deductible on your client's state tax return. It's also time to revisit tax withholdings.

“Getting married, having a new child — all that may add potential deductions and allow you to adjust your withholdings,” said Mr. Jenkin. “Many people don't think about it: What are the other deductions?”

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