Even if you are one of the millions of working adults who hire tax-prep professionals to file your return each year, it’s important to know the basics of persona income tax strategy. Why? Because even the best CPA or tax attorney makes mistakes. Plus, these experts don’t know what your intentions are unless you tell them. For example, you should inform your CPA that you plan to make a large charitable contribution in an upcoming year. Armed with that information, an accountant can structure your filing to maximize the effect of your donation, and thus minimize the amount you pay to the government. What are the five things everyone should know about personal taxes, even if they hire a professional to do all the paperwork for them?
Here is the basic information about each one.
Recent laws have had a major effect on donations. Under the new law, it’s much less advantageous for most taxpayers to itemize their deductions. That mean unless you have a large dollar amount of charitable giving to report, it’s often best to take the standard deduction and forget about itemizing. That doesn’t mean you shouldn’t give to worthy causes. Quite the contrary. Since the new law went into effect last year, many charities have been struggling to maintain the same level of donations they received in years past. Now, more than ever, some of the nation’s most essential non-profit organizations need your help.
If you work for yourself, you have to pay the Social Security and Medicare taxes yourself. That means coughing up an additional 15.3 percent of earned income, after business deductions. You won’t need to pay self-employment (SE) tax if you earn less than $400. When you file your return, you have to include a Schedule C to report business income or loss. Note that you can deduct relevant business expenses to offset gross business income. But then you must pay 15.3 percent on the net income that falls into the self-employment category.
Modified Endowment Contracts (MEC’s)
Anyone with a life insurance policy needs to know the basics of the modified endowment contract, also called a MEC for short. That’s because there are strict IRS rules that govern how money can be withdrawn from a life policy vs a MEC. When you buy a whole life policy and pay too much into it within the first seven years, the IRS assumes that it’s no longer an insurance policy but an investment vehicle. They treat it more like an IRA or an annuity after that point. So, what’s the big deal for policyholders? There are two main pints to understand. One, if you do not plan on withdrawing money from the policy during your lifetime, it can be a good idea to place a large sum of money into a whole life policy, even if the IRS determines that it’s a MEC. Your only penalty for losing the status of insurance and falling under the MEC definition is that early withdrawals can be taxed as ordinary income and penalized at a rate of 10 percent. But that won’t matter to you as long as you don’t take cash out of the MEC.
If you leave every penny in the policy/MEC, the entire amount transfers to the beneficiary, tax-free, upon your death. People use this strategy to park large sums of money into whole life polices within just a few years. Then, when they die, all the money passes to their designated beneficiaries without going through the courts. Plus, it passes tax free. If you are currently over-paying your premiums, for whatever reason, into your life policy, speak with your agent and do some research on your own to find out whether you are in danger of involuntarily converting the policy into a MEC.
Get your documents together as soon as possible after January 1st each year and file your return. There are two advantages to being an early bird when it comes to taxes. One, you won’t have to worry about running out of time if a complication arises. You and your preparer will not be fighting the clock is there’s a W-2 or 1099 missing. Starting on January 1 removes the rush factor from the entire filing process. Second, if you have a refund coming, you’ll get it much faster, sometimes months faster. Waiting until the April deadline can mean not receiving your refund until mid-summer. There’s no sense in waiting on your own money, so file early and avoid the rush.
Double-Check Everything Before Filing
Your CPA or attorney might be the best in town. Still, you want to double-check all the math and look at your prepared return for major mistakes before it goes to the IRS. In the real world, CPA and law firms use tax software to prepare client returns. Then, a human being usually scans each document for accuracy, math correctness, and omissions. However, most professional tax preparers will ask you if you want to look at a hard or digital copy of your return before they file them. Don’t ignore this step of the process. Simply take the paper or digital return and check the arithmetic. Then, see that your wish to either itemize or take the standard deduction was honored. Finally, go over any SE tax calculation, investments, other schedules, Social Security data, and the rest of the return for accuracy.