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Anatomy of a tax return (Part 7) – Tax refunds and Tax payments

February 09, 2023

The last article in this particular series is we are now going to look at taxable income, tax liability and tax payments. 

Whether you owe tax or get a refund when you file your tax return is the culmination of everything discussed in the previous six articles. If you did not read those I encourage you to go back and do that. 

Everything that we've talked about before - gross wages, investment income, retirement income, capital gains, other income with its massive variety of income types and then standard or itemized deductions and QBI brings us to what is called taxable income.

On your Form 1040 for 2021 it's at the bottom of page one, everything above arrives at this one amount -  taxable income.

Then on the top of page two is where the tax you owe on this income is shown. The tax is based off of taxable income and there might be different rates for different types of income.

But to keep it simple you can see that everything that you do above whether you are increasing your income or you are finding legitimate deductions that lower your taxable income, the lower the taxable income, the lower the total taxes are that you owe for that year.

If you wonder what your effective tax rate is, you can simply divide that tax number into your taxable income and that'll be your effective rate.

Now, as you work down to line 25, there are other adjustments to tax such as if you're self employed you might also have self employment tax and there might be some tax credits.

When you arrive at Line 25 that’s the line called Total Tax  That's really the tax that you owe for the entire year. That is the amount that people should be focusing on first before whether or not you get a refund or owe more tax when you file your return.

Below Total Tax are payments you made during the year and credits you are entitled to.  Taxes that you paid during the year are most commonly taxes that were withheld from your paycheck or retirement income or perhaps quarterly estimated tax payments that you made.

It could also have been a tax refund in the prior year that you chose to have applied to this year’s tax bill instead of get a refund back in that year.    

This section also includes credits that you may be entitled to and for the last couple of years is where most of the Covid related credits showed up.

Your total tax owed minus all the payments that you've made for this tax year brings you to the point of whether you get a refund or you still owe more.

While whether you get a refund or owe more is certainly an important item to know on your tax return, many people miss the much bigger picture of what was the total tax owed and how they can impact that.

For example, what if you got a $3,000 tax refund?  Yay.  But what if you looked closer at your return and saw that it was after owing $50,000 of tax and having paid in $53,000 of tax.  Now with everything we’ve talked about in the past episodes you realize that with some advance planning you could have only owed $45,000 instead of $50,000?

These are obviously just examples, but the point is what you get as a refund or you owe when you file your tax return is just a tiny little part of your overall tax picture that you should be planning for.

For my long time subscribers, you’ve seen me say this before, as a financial planner I’m not just looking at future retirement income but future tax effects. Sometimes you may want to avoid tax now and pay it years from now.  Possibly in some cases you might not want to avoid tax now and instead pay it now to avoid a much larger tax bill years in the future.

Which approach is right for you?  Depends on your unique situation.

It’s not inconceivable that you might earn $1,000,000 in your working lifetime and even into retirement.  If you worked for 30 years and earned an average of $33,333 per year, you would have earned, pretax $1,000,000 over the course of your working years.   For simplicity, let’s assume you were in a 15% effective tax rate that entire time, that’s $150,000 of taxes paid across those 30 years.

This is not even counting any income in retirement that you might also owe tax on.  The point is that even relatively small changes to your tax footprint multiplied across years or even decades can have a large effect.

That’s why I am a firm believer that working with a tax preparer and a financial planner that is willing and able to help with tax planning and not just tax preparation or retirement planning as a stand-alone activity is a valuable person to have on your financial health team.

So with that, we will wrap up this series. If you have any questions, feel free to reach out. If you are working with a tax preparer and they are only focused on this year’s tax return consider if that’s all you need or you are looking for more.

If you're working with a financial advisor that is not giving you tax advice because they can’t, won’t or don’t know what to tell you, then with all due respect I believe you are being done a disservice because taxes are a huge part of your overall financial plan.

I hope this series has been helpful and if you have other topics feel free to send a note and I’ll see if I can include it in a future article.

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The information in this and other articles is intended to be educational in nature only.  Not tax, legal or investment guidance for you specifically.  Each person’s situation is unique and you must seek appropriate professional guidance that can address your unique situation.

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