** Disclaimer – Every financial situation is different and tax laws change frequently. When in doubt, you should consult with a tax professional or financial advisor for guidance specific to your situation. **

It was Ben Franklin who said that only two things are certain: death and taxes. We spend a lot of time here at Seeking Excellence preparing our souls for the first, but with the July 15th deadline for personal income tax returns coming up soon, let’s spend some time talking about the second.

For many years, I dreaded the prospect of doing my tax returns and had little confidence that I was doing it right. Having learned a few tax lessons the hard way, I believe that understanding and navigating the US tax code is one of the quickest ways you can dramatically change your disposable income and financial circumstances without earning a single cent more.

Here’s hoping you can learn from my mistakes and reach your financial goals that much faster.

< Why getting a big refund isn’t necessarily a good thing. >

Turbotax, H&R Block, and other tax prep software are great resources for the individual tax preparer. These services all tout some variation of a “max refund guarantee” – that they will get you the biggest refund possible, or your money back. As a result, many people tend to think that getting a big refund is all that matters. It’s easy to think you are on the right track financially if you get a big check from the government, but things are not always as they appear.

You are probably asking yourself, “Why would I not be happy about the government giving me money?”

Because, my dear Watson, filing your tax returns is not the same thing as paying your taxes.

It may come as a surprise to you that you pay your taxes year round. On every paycheck, your dear old Uncle Sam withholds a certain amount based on the income you earned during that pay period and the W-4 you filled out your first week on the job and probably haven’t thought about since. Filing your tax returns is simply the process of confirming with federal, state, and local governments that you’ve already paid the right amount, and if you didn’t, paying what they are owed or requesting they refund what you overpaid.

So, when you get a check back from the government, it means you gave them too much over the last 12 months. You’ve essentially given the government a short-term loan with an interest rate of zero percent. Your bank usually doesn’t give you that courtesy on your car loan, mortgage, or credit card balance – so why would you do the same for the government?

Some people deliberately choose to have extra taxes withheld from their paychecks so they can be certain they won’t unexpectedly owe money, and for good reason; a surprise tax liability can have serious consequences if you’re not prepared for it. But remember, “getting the best refund possible” is NOT a financial goal. Financial goals are saving for retirement, college, a down payment on a house, or the like. As with many things in life, the best path is the middle road. Aim to withhold accurately - no more and no less than what the government is due. As long as you have the discipline to save and invest that money over the course of the year rather than spend it, it’s better off in your pocket than Uncle Sam’s.

< Gross income, AGI, taxable income, & deductions – know the terms and why they matter. >

So, you’ve stopped giving Uncle Sam a free ride on your hard-earned dough; now, let’s figure out how to give him less of it entirely.

To do that, we need to first understand a few terms that I have personally misused and misunderstood for longer than I’m inclined to share publicly. To start, a few definitions:

· Gross income:all income received from all sources – for example, wages, salary, bonuses, interest, and dividends.

· Adjusted gross income (AGI): your gross income, less any adjustments to income (defined later).

· Taxable income: your AGI, less the greater of your standard or itemized deductions.

· Adjustments: Also known as “above the line” deductions, these reduce your AGI - for example, student loan interest, individual retirement account (IRA) contributions, or health savings account (HSA) contributions.

· Standard deduction: a flat amount (corresponding to filing status) deducted from your AGI to calculate your taxable income.

· Itemized deductions: Deductions that may reduce your taxable income if, in aggregate, they exceed your standard deduction - for example, charitable contributions, mortgage interest, out of pocket medical expenses, or state/local taxes paid.

These concepts are deeply interwoven, and how well you leverage them can result in vastly different outcomes for your financial health.

Figure 1: The Russian Nesting Dolls of Income

As the name suggests, your taxable incomeis what you actually pay taxes on. The real tax ninjas are the people who minimize their taxable income as much as possible without changing their gross income. They keep more of the pie for themselves AND keep the pie the same size.

How do they do that? First and foremost, they know the power of adjustments. What is so powerful about adjustments is that you keep the income AND reduce your taxable income dollar for dollar – that is, if you contribute $1,000 to your IRA, you reduce your AGI and taxable income by $1,000. On the other hand, itemized deductions such as mortgage interest, charitable contributions, and the like only reduce your taxable income if they add up to more than the standard deduction for your filing status.

< Theory into practice: Martha and Mary >

Putting it all together, consider two filers, Martha and Mary. Martha and Mary are both single, with a $68,000 salary and a $2,000 annual bonus. They both contribute $8,200 to charity and save $9,000. Where they diverge, however, is how they save their $9,000.

Martha keeps her savings in a personal checking account; fundamentally not that different from the piggy bank she had as a child.

Figure 2– Martha. Not a tax ninja.

Mary, on the other hand, is a tax ninja, and knows the power of adjustments. Instead of letting that $9,000 sit in a regular checking or savings account, Mary set up automatic monthly contributions straight from her paycheck into her tax-advantaged 401(k) and health savings account.

Figure 3- Mary, a tax ninja.

Just by changing how she is saving her money, Mary reduced her tax liability by nearly $2,000, or 25% less than Martha’s. Looks like Mary can afford that Peloton after all, while Martha is left wondering why she can never seem to get ahead. Nice one, Mary.

< Things to do right now >

So what can you do to be more like Mary and less like Martha?

1. Review your W-4 on file with your employer. If you’re consistently getting big refunds, you’re probably withholding too much from your paychecks. You should review and update your W-4 anytime you have a major life event, such as getting married or having a child.

2. If you didn’t take advantage of adjustments last year, it’s not too late – generally, you can make contributions to tax advantaged accounts for the previous year up until the filing deadline. If you’ve already filed your taxes, it’s still not too late - you can file an amended return.

3. Save yourself a few hundred dollars on filing by checking if you’re eligible for Turbotax’s Freefile program. If you qualify for the earned income tax credit, have an AGI of less than $39,000, or are an active duty servicemember with an AGI of less than $69,000, you qualify.

I hope it helps. Happy Tax Season.

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