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Luke Landes

If you haven’t noticed, it’s tax time. I have noticed, not only because of the endless emails I receive reminding me of this grand celebration, but also because of the people with whom I interact. As those I know complete their tax returns, I observe their pure joy as they realize they’ll be receiving a refund from the IRS.

owe-more-refund

Count me in with the masses; my accountant suggested some changes to my tax returns for the past couple of years, and I received several refunds I otherwise wouldn’t have expected. I exuded an appropriate level of joyfulness, as well.

Most people’s tax situations are much simpler than mine. For example, a single guy might work for only one employer, receive one W-2 form, and won’t have much un-withheld income. He will probably receive a small refund. Or a family receives two W-2 forms and, because they didn’t calculate their withholding correctly, they’ll receive a large refund. Cue cheers of joy!

Except, the federal government should be the one celebrating. They’ve been using “our” money — money belonging to those of us who are due a refund — for free! Usually, when you lend money to someone, you charge interest to compensate yourself for its use. Why would you give the government, an organization that will use your money in ways you may not approve, a free ride?

The most common explanation — or rationalization — for not being concerned with lending money to the government for free is simple. It’s because this creates “forced savings.” By having more money than necessary withdrawn from each paycheck, you are automatically putting some money aside for later. You’re just counting on the government to pay you back on time, of course (and without interest).

It might be a good idea to note that some state governments are not issuing refunds on time. The states’ financial difficulties will become your financial difficulties when they delay sending you the “savings” you’ve been counting on.

Even if your return arrives lightning quick and without problem, it’s still a ridiculous situation. But, most of us stand for it, year after year. Why don’t we break the cycle of free loans to the government, then strange joy when our money is returned?

Let’s start with the typical rationale. Here’s why “forced savings” is a poor excuse:

  • You are not earning interest. In a high-yield bank account like Barclays, the money could earn interest. If you hand excess money to the government each pay period, the government gets to keep any interest it could be earning. You might as well throw money out the window.
  • You don’t have use of the money. The average tax refund, for those who receive one, is almost $3,000. You could have used that money to pay off your debt, repair your house, or invest for your retirement.
  • Saving yourself isn’t difficult. Don’t rely on the government for a savings plan. You can automatically transfer a portion of your paycheck into a savings account, and not even think about it (essentially, the same thing you’re already doing). When you re-calculate your withholding and change the form with your employer, set up direct deposit so you receive your pay directly in your bank account. Then, set up an automated recurring transfer to move a portion of your pay into a savings account that’s earning interest.
  • It’s easy to treat a refund wrong. Receiving a large check from the government encourages people to make unnecessary or unplanned purchases. While that might be great for the economy in general, you might be making choices you wouldn’t have been if that money was spread out over the course of the year. If it were incorporated into your weekly or biweekly income, you would be more apt to budget it wisely.

The federal government counts on millions of citizens overpaying their taxes throughout the year. In fact, if everyone optimized their withholding, the government might not be able to pay for its day-to-day operations. But you don’t need to worry about what the government will do in that situation. The best decision for your financial health is to optimize your withholding so you do not receive a substantial refund.

In fact, you should consider planning your withholding so you owe the government when you file your taxes. In this scenario, all the drawbacks mentioned above become your advantages. You’ve had access to government money throughout the year. As long as you stay within limits, you won’t owe the government any interest or fees. You can even earn interest or invest the government’s money, tucking that cash into an interest bearing account, ready to pay your tax bill when it comes due.

Of course, be sure to keep track of approximately how much you’ll owe, and never put yourself in a situation where you cannot pay your tax bill by the deadline in April. If you’re going to avoid a tax refund, you need to be smart and not create a bigger issue. But, as long as you can pay your bill by April 15 (or April 18, as it is this year), the government doesn’t care what you do.

 

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At the end of the year, most people in the United States are thinking about the holidays and the potential credit card bills for gifts and family visits. One good way to control this potentially stressful month is to take some time to breathe and get your own finances in order. There are several actions you should consider and complete before the year ends in order to start next year on the best foot possible.

A few weeks ago, the IRS announced that the 2017 individual contribution limit toward a 401(k) retirement account will remain unchanged from 2016. Anyone financially comfortable enough to maximize the contribution will be able to tuck away $18,000 this upcoming year (the same as they could this past year). Savers aged 50 or older qualify for an extra $6,000, in addition to the $18,000, for a total contribution limit of $24,000.

If you plan to maximize your contribution, and did so this past year, you don’t need to make any changes. However, if you didn’t reach the contribution limit this year but plan to do so in 2017, take some time now to plan.

Contact your benefits department via phone or website and change your deductions for the upcoming year. The changes could take a few weeks to go into effect. If you want the increased contributions to take effect at the beginning of the year, it’s best to start looking at the details now.

Calculate Based on Employer Match

In many cases, employers offer some sort of matching contribution. For example, the company might match half of your contributions, up to the first 6% of your salary that you contribute. Or, perhaps they’ll match all of your contributions up to the first 3% of your salary.

Let’s take the first case. In order to maximize your tax benefit and matching benefit, you’ll need to deduct 6% of your paycheck every period, if 6% of your annual salary adds up to $17,000 or less ($22,500 or less if you’re 50+ years old). In the second case, you’ll only need to deduct 3% of each paycheck. If the optimal percentage would result in exceeding the government-mandated maximum, you’d have to determine the best percentage that prevents you from exceeding that threshold.

Special Provisions

I found out recently that some employers offer a benefit, sometimes called something like “spillover protection.” Let’s say you contribute more than the IRS maximum. Companies that offer this feature will allow you to continue deferring income to your 401(k); it would just be considered after-tax contributions. Most other employers would just automatically stop your contribution once you hit the limit. So why is this a nice benefit to have? Well, for those whose deferments automatically stop, and whose employer matches contributions on a per-paycheck basis, they’ll miss out on some matching contributions. Essentially, they’re giving up free money. With this spillover protection, their employer will continue contributing their match (the free money) up to the limit, versus leaving it on the table.

Employers may also have other contribution limits. It’s common for a corporation to say that the maximum contribution percentage is 50% of an annual salary. Be sure to check into your benefits and plan out the year’s contributions accordingly.

Not Maxing Out Contributions This Year?

Recalculating the 401(k) contribution at the end of the year is not a tactic just for those earning enough to maximize the tax benefit. Let’s say you received a raise or cost of living increase this year and haven’t adjusted your 401(k) deferment to match the extra cash flow. The end of the year is a good time to bump your contribution by one or two percentage points. Some 401(k) plans have options where the investor can initiate automatic investment increases each year. This is a good opportunity to turn this feature on or manually adjust your contribution.

This advice also isn’t just for people working for large corporations. Non-profit organizations often offer similar benefits called 403(b) plans, and if you’re self-employed, you may save for your retirement using an individual (or Solo) 401(k) plan.

Don’t wait. The process of changing your contribution can take a few weeks to take effect, so if you want to contribute a consistent percentage of your income throughout the new year, the sooner you make the change, the easier that will be.

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With the holidays approaching, many companies are preparing their bonus checks. However, some employees who are looking forward to their bonuses are also concerned about tax consequences.

I gave up this “extra” part of my corporate pay, in exchange for the benefit of working for myself, when I left my day job a few years ago. An annual bonus was certainly an appreciated part of my income, however. However, if this year’s holiday season is anything like years past, I know I can expect people around me to complain that they’d rather not receive a bonus. But why?

There is a widely-held belief that the extra income from a bonus — which is not really extra, just a variable aspect of compensation — supposedly bumps them into a higher tax bracket. This, they believe, is bad. They believe that they could potentially owe the government a higher tax rate on all of their income. This is incorrect and represents confusion about how marginal tax rates work.

These misconceptions and the resulting complaints are intensified when the bonus check arrives. Typically, they’ll see a net payment amount representing only a fraction of the gross income listed on their pay stub. This only fuels the anti-bonus fire.

What a Bonus Actually Does to Taxes

For most taxpayers, the IRS treats bonus income the same as regular income. All taxable W-2 income gets added together in one box when you file your federal tax return forms. The same tax rates apply to each dollar shown, whether it came from your 9-to-5, your side hustle, weekend babysitting, or a holiday bonus.

There is a catch, though, and is the reason this confusion runs rampant. While the IRS doesn’t discriminate between regular pay and bonus pay, employers often do.

How Employers Calculate Taxes

Employers can choose between two primary methods of withholding federal taxes from bonus or supplemental income. This applies when said “extra” income is given to the employee in a check or direct deposit separate from regular income.

Option 1: The employer may withhold a flat 25% for federal income taxes from the bonus payment. If the employee receives over $1 million in bonus payments in one year, the employer can withhold 25% of the first $1 million in addition to 35% from the amount over $1 million.

Option 2: The employer may add the bonus payment to the most recent regular income payment. They would then determine the standard withholding based on tax tables and the sum of the two payments. Then, subtract the amount already withheld from the most recent regular income payment, and withhold the rest from the bonus.

*Option 3: The employer may base withholding on the sum of the bonus and regular pay using the standard withholding tables. *This option is for employers who choose to combine bonus compensation with regular compensation in one payment, check or direct deposit, without any differentiation between the two types of income.

Regardless of the method the employer chooses, bonus income and regular income are grouped together when you file your taxes. The IRS will refund any overpayment and will collect any underpayment.

Outliers

One interesting exception to the rule of bonuses being taxed the same as all other income applies to hedge fund and other investment managers. This type of income is known as carried interest. Investment managers often take their bonuses from investment gains, and these can be taxed at the long-term capital gains rate of 15%. This rate is usually significantly lower than their marginal tax rates.

My Final Advice

Don’t be afraid of earning that bonus or more money in general. Your employer might withhold more of the check for taxes than you’re used to, but it will even out when you file your taxes.

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401(k) plans are the primary retirement savings vehicle for the middle class, particularly as more employers enroll new employees automatically in the plans. And for those who have the ability to maximize their contribution each year, the new calendar year offers an additional opportunity.

In 2015 and 2016, the maximum contribution limits were the same. For retirement accounts — which include 401(k) accounts, 403(b) accounts, most 457 plans, and Thrift Savings Plans — these stayed at $18,000. In case you were holding out for an increase, I have bad news: for 2017, these contribution limits have remain unchanged.

Of course, savers and investors aged 50 or older can take advantage of a catch-up contribution. This effectively increases the limit for those approaching traditional retirement age. In 2017, taxpayers who meet this age-based criterion can contribute an additional $6,000 above the regular maximum of $18,000. As a result, if you are 50 or older, you can contribute a maximum of $24,000 into these tax-advantaged accounts. (This is also the same as the past two years.)

Resource: Maxed out your 401k or looking for better investment options? Check out an IRA at WealthFront.

The total contribution limit, including employer contributions, has changed, however. It is now at $54,000, up from last year’s $53,000.

The benefits of a 401(k) plan are, by design, directed primarily at people who most need an incentive to save for retirement. This may help contain the tax benefits within the middle class. The government does this by applying a maximum level of compensation to which matching benefits apply.

In 2017, only the first $270,000 in an employee’s compensation over the course of 2017 may be applied to the company’s matching formula. That income limit has grown from $265,000 in 2016.  That’s a sufficiently high maximum and should cover more than just the middle class.

To illustrate, if a company matches an employee’s contributions at a rate of 50% up to a limit of 5% the salary, an employee with a $100,000 salary deferring $15,000 will receive at most a $5,000 matching contribution (5% of the full $100,000 salary). If an employee at the same company ears $400,000 in compensation throughout the year, deferring $15,000, the matching contribution will be $13,500 (5% of the $270,000 maximum compensation, not $20,000). There are additional rules in place that require a company to balance benefits between highly compensated employees (those earning $120,000 or more) and all others.

Beginning in 2013, new regulations required 401(k) plan administers to explicitly state in quarterly statements how much investors are paying in fees. Previously, this information was not easy to discover. While you could (and should) look at the various prospectuses in search of management expenses fees or expense ratios, expressed as a percentage of assets, there were at least two obstacles:

  • The expense ratios force you to do your own calculations to determine how much money you’re spending in fees.
  • Not all fees are included in expense ratios. Some funds, like annuity-based mutual funds, don’t have expense ratios but certainly have fees.

To maximize your 401(k) contribution in 2017, spread the $18,000 across the number of paychecks you plan to receive throughout the year. That’s a contribution of $1,500 each month, $750 twice a month, $692 every two weeks, or $346 a week for those age 49 or younger. The calculation for those over 50 who want to max the contribution are $2,000 per month, $1,000 twice a month, $923 every two weeks, or $461 a week.

If your contributions are recorded in the form of percentages, don’t forget to change your contribution to take into account raises and bonuses. If you are expecting your company to match your contributions at some level, and you reach your 401(k) contribution limit before your last paycheck, you may miss out on free money.

The following table illustrates the change in 401(k) contribution limits over the past several years.

Year 401(k)
Maximum
Catch-Up
Contribution
Maximum
Allocation
2017 $18,000 $6,000 $54,000
2016 $18,000 $6,000 $53,000
2015 $18,000 $6,000 $53,000
2014 $17,500 $5,500 $52,000
2013 $17,500 $5,500 $51,000
2012 $17,000 $5,500 $50,000
2011 $16,500 $5,500 $49,000
2010 $16,500 $5,500 $49,000
2009 $16,500 $5,500 $49,000
2008 $15,500 $5,000 $46,000

Photo: urban_data

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2017 IRS Standard Deductions and Exemptions

by Luke Landes
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Most taxpayers can choose between itemizing tax deductions to reduce taxable income, which requires accurate record-keeping and support, and taking the standard deduction. The standard tax deduction is a fixed amount that reduces the amount of money on which year-end taxes are calculated. Generally, if you can show that you’ve had more deductible expenses than […]

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The Best Cash Back Credit Cards of 2017

by Luke Landes

Cash back credit cards can help consumers practice responsible spending while earning a little extra for their efforts when used properly. The days of earning 5 percent cash back on all credit card purchases may be just a memory, but the smart use of credit cards can still be profitable for diligent consumers. You may […]

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Thank You: Twelve Years of Consumerism Commentary

by Luke Landes
Original Consumerism Commentary

Thank you to Consumerism Commentary readers.

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Life Is Short: Toxic Financial Attitudes

by Luke Landes
Drinks on beach

There’s a good reason I can’t get into extreme savings for retirement. When desperate financial times call for desperate financial measures, there is a good incentive to cut all unnecessary spending and eliminate bad debt. Many people even wait until they hit rock bottom before reforming their approach to their finances, because the effects of […]

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Podcast 175: Carl Richards, The One-Page Financial Plan

by Luke Landes
Carl Richards

It may have been over a year since I last put together a podcast episode, but I’m back today to talk with Consumerism Commentary Podcast guest Carl Richards. Carl is here to talk about his new book, The One-Page Financial Plan: A Simple Way to Be Smart About Your Money. The author will also be […]

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Command and Control: From Baseball Pitches to Your Money

by Luke Landes
Matt Harvey

When your life is out of control, nothing seems to go right. You have the worst luck, and you can’t seem to get ahead with anything, whether a project, a goal, or even simple things like taking care of daily tasks. Regaining control of your life is imperative. For your finances, you can do that […]

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