While the refund really means you’re getting back money you loaned to the government at no interest, in practical terms it often means an unexpected infusion of cash into your wallet or bank account. Last year’s average income tax refund was $2,755, according to the Internal Revenue Service. That’s a nice chunk of change.
It’s a great problem to have: What do you do with your windfall?
The best choice for one person may not be the best choice for another. But experts agree on one thing: If you have debt, apply your refund to paying it off, whether it’s credit card debt, student loan debt or other consumer debt.
“People should still be focusing first on paying down debt,” says Meisa Bonelli, a Wall Street finance and tax professional whose Millennial Tax company advises entrepreneurs on business and tax strategy.
Debt, particularly student loan debt, should be a primary target because it limits financial options, preventing people from doing what they want with their money, whether it’s buying a house, buying a car or taking a vacation. “Get that debt gone,” she says. “It holds you back from everything else you want to do in life.”
Eric Rosenberg, a financial analyst who writes the blog Narrow Bridge Finance, agrees. “The No. 1 thing anyone should do with a tax refund is pay down debt,” he says.
After he left graduate school with $40,000 in student loan debt,
he focused on aggressively paying it off. Using all his tax refunds and bonuses, he made the final payment just two years and six days after his graduation.
With his student loan debt cleared away, he began saving his tax refunds, with the goal of buying a home. He didn’t apply any of his refund money to splurges — instead, he saved for fun and vacation with his regular income. The refunds were earmarked for bigger things.
“I treated it like it was extra money that I didn’t need to live on,” Rosenberg says. “I always encourage people to think long term, not short term.”
Others believe that giving yourself license to splurge with part of your refund helps you save the rest. Stephanie Halligan, a financial consultant and blogger, signs a contract with herself before she does her taxes, allocating 50 percent of her refund to student loans and 25 percent to long-term savings. She can spend the remaining 25 percent on whatever she wants.
“It’s easy to react on impulse and emotion when your refund hits, so prepare now for what you’ll do with that moolah later,” she advises on her personal finance website, The Empowered Dollar.
If you’re getting a big refund – a check in the ballpark of $1,000 or more for taxpayers who don’t have a side business — consider adjusting your withholding so that you’ll have that money available to you during the year. But those who don’t have substantial savings want to avoid a scenario in which they owe four figures to the IRS at tax time.
“I think people should withhold the maximum they can withhold,” Bonelli says. Rosenberg concurs. As his businesses, running Narrow Bridge Finance and building websites, have grown, his refunds have shrunk. Last year he had to pay the IRS.
Here are the seven smartest things you can do with your refund:
Pay down debt. If you have any consumer debt — student loans, credit card balances or installment loans — pay those off before using your refund for any other purpose. Car payments and home mortgages aren’t in this category, but you can consider paying extra principal.
Add to your savings. “You can never save enough,” Bonelli says. You can use the money to build up your emergency fund, your kids’ college funds or put it toward a specific goal, such as buying a house or a car or financing a big vacation.
Add to your retirement accounts. If you put $2,500 from this year’s tax refund into an IRA, it would grow to $8,500 in 25 years, even at a modest 5 percent rate of return, TurboTax calculates. If you saved $2,500 every year for 25 years, you’d end up with more than $130,000 at that same 5 percent rate of return.
Invest in yourself. This could mean taking a class in investing, studying something that interests you or even taking a big trip. “Do something that enriches yourself or adds value to your life,” Bonelli says. She is planning to take a class in art therapy this year using money from her refund.
Improve your home. Consider putting your refund to good use by adding insulation, replacing old windows and doors or other improvements that would save energy, and therefore money. Or perhaps it’s time to remodel your bathroom or kitchen. You’re adding value to your home at the same time you’re improving your living experience.
Apply your refund toward next year’s taxes. This is common among self-employed taxpayers, who are required to pay quarterly taxes since they don’t have taxes withheld. By applying any overpayment toward upcoming tax payments, you can free up other cash.
Splurge on something you’ve always wanted to do. If you’re out of debt and have substantial savings, this may be the time to take the trip to Antarctica or Australia that you’ve always dreamed of taking. Such an experience can be life-changing, and you never know what impact it will have on your future until you actually do it.
Source: DailyFinance.com. “7 Smart Ways to Take Advantage of Your Tax Refund.” By Teresa Mears. March 31, 2014.
Between income taxes, property taxes, sales taxes and all those other taxes, the amount of your income that flows into government coffers adds up quickly.
One way to think about its is to figure out how much of your working year goes to covering your taxes. The conservative-leaning Tax Foundation calculates annually how many working days it takes for the average American worker to earn enough to pay all his federal, state and local taxes , plots it on the calendar, and dubs it “Tax Freedom Day.”
Last year, that day was April 18, reflecting that Americans on average paid 29.4 percent of their income in federal and state taxes. But that date varies widely from state to state.
Early Freedom From Taxes
Residents in different states see varying percentages of their income go toward taxes for a variety of reasons. State tax rates vary. So does relative income, with less prosperous states tending to pay lower federal tax rates than those with more high-income taxpayers.
The lowest-tax states in 2013 were Louisiana and Mississippi, whose Tax Freedom Days were both March 29. All five lowest-tax states were in the South, with Tennessee, South Carolina and New Mexico rounding out the top five.
All five take a relatively low percentage of their residents’ income in state and local taxes. Most rely on sales taxes; South Carolina’s the exception, with a high level of revenue from property taxes. Louisiana and Mississippi boast the highest percentage of federal aid of any state, getting back from Washington far more than they send to it.
Paying More Tax, into May
At the other end of the spectrum, Connecticut residents took the longest to account for their taxes in 2013, with a Tax Freedom Day of May 13, outlasting No. 2 New York by a full week. The Northeast dominated the top of the list, with New Jersey and Massachusetts coming in third and fourth, and Illinois taking No. 5.
Most of these states are among the highest in terms of state and local taxes paid per person, reflecting their relative wealth. All five also take more than 10 percent of their residents’ income in the form of state and local taxes, with New York exceeding the national average by almost 3 percentage points.
Property and state income taxes make up a huge portion of the revenue sources for these states, taking advantage of the extensive property holdings and high income that their residents enjoy.
What’s Your Tax Freedom Day?
A Tax Foundation map shows the 2013 Tax Freedom Day for your state. The announcement of Tax Freedom Day 2014 is expected to come soon.
Source: DailyFinance.com. ” 3 Months Into 2014, You’re Likely Still Working for the Tax Man “. By Dan Caplinger. March 31, 2014.
The Internal Revenue Service’s decision to treat Bitcoin as property will make tax consequences part of every transaction involving the virtual currency.
So much so that Bitcoin users and analysts say the IRS guidance announced yesterday complicates people’s ability to use it as a currency.
“This greater clarity creates greater wrinkles,” said Mark Williams, who teaches finance at Boston University. “This reinforces that strategy of holding it as a commodity, which then undermines its value as a transactional currency.”
The IRS, faced with a choice of treating Bitcoins like foreign currency or property, chose property. Exchanging Bitcoins for goods, services or dollars will generate taxable income or losses, depending on what the Bitcoin investor paid.
The IRS ruling could reduce the volume of transactions conducted with the virtual currency, said Pamir Gelenbe, a venture partner at Hummingbird Ventures. The firm invests in technology businesses.
Purchasing a $2 cup of coffee with Bitcoins bought for $1 would trigger $1 in capital gains for the coffee drinker and $2 of gross income for the coffee shop.
“It’s challenging if you have to think about capital gains before you buy a cup of coffee,” Gelenbe said.
Jered Kenna, a San Francisco-based entrepreneur who owns Bitcoins, said in an interview that after hearing about the IRS guidance he needs to “talk to my accountant.”
More seriously, Kenna said the new rules would complicate the smooth functioning of the Bitcoin payment network.
“You’re increasing the cost of accounting to everyone who touches a Bitcoin transaction,” Kenne said.
Others involved in Bitcoin downplayed the effects of the decision, saying it provides needed certainty for investors. Also, because Bitcoins are a long-term investment, much like stocks, the IRS ruling didn’t surprise them.
The ruling takes effect immediately and covers past and future transactions and tax returns. The IRS said in its notice that it may offer relief from penalties to people who engaged in transactions before yesterday and can show “reasonable cause” for underpayments or failure to file.
Bitcoin, the most popular digital currency, emerged from a 2008 paper written by a programmer or group of programmers under the name Satoshi Nakamoto.
The Bitcoin network uses a public ledger to record transactions made under pseudonyms, a technological breakthrough that allows purchases and sales without using a trusted third party, such as Visa Inc. or Western Union (WU) Co.
Powerful computers that record the transactions and guard against double-spending the same currency generate new Bitcoins, a process referred to as mining. Mining has made some early Bitcoin adopters wealthy in dollar terms.
Others bought into the currency in early 2013, before its price rose more than 50-fold to peak at $1,200 in early December. Bitcoin was priced at $581.86 at 8:05 p.m. New York time yesterday, according to the Coindesk Bitcoin Price Index.
In March 2013 the Financial Crimes Enforcement Network, like the IRS a part of the Treasury Department, acknowledged digital currencies like Bitcoin are fundamentally different than dollars. It said companies exchanging Bitcoins for dollars can be regulated as money transmitters.
That triggered a race among states, notably New York and California , to ascertain how or if their laws apply, since states typically license money transmitters. The Bitcoin industry has been frustrated that parts of the U.S. government are regulating the virtual currency in different ways.
“You see guidance from on high with no public input, which is unfortunate,” said Patrick Murck, general counsel for the Bitcoin Foundation.
The IRS ruling means Bitcoin investors will be treated like stock investors. They must determine their basis, or cost paid, for the Bitcoins, so they can tell whether a particular transaction results in a gain or a loss.
Someone who bought a Bitcoin for $400 and sold it for $500 would have $100 in capital gains.
Bitcoins held for more than a year and then sold would face the lower tax rates applicable to long-term capital gains — a maximum of 23.8 percent. That compares with a 43.4 percent top rate on property sold within a year of purchase and the 39.6 percent top rate that applies to other types of income.
For investors with losses, U.S. tax law allows taxpayers to subtract capital losses from any capital gains.
Beyond that, they also can subtract as much as $3,000 of capital losses a year from ordinary income.
If Bitcoin were treated as a foreign currency, ordinary — not capital gains — tax rates would apply. Losses would be easier to deduct against ordinary income, however.
As with stocks, Bitcoin dealers will be subject to different rules that won’t allow for capital gains treatment.
Bitcoin miners will have to report their earnings as taxable income with a value equal to the worth on the day it was mined. They would use that as their cost basis and then pay gains or record losses when they sell or exchange the Bitcoins.
If they mine as part of a business, they’d have to pay payroll taxes as well.
The IRS will require information reporting similar to how the tax agency receives notification of stock transactions and payments to independent contractors.
It comes less than three months after National Taxpayer Advocate Nina Olson called on the IRS to issue taxpayer guidance on digital currency transactions.
“It is the government’s responsibility to inform the public about the rules they are required to follow,” Olson, who runs an independent office within IRS, wrote in her annual report to Congress in January. “The lack of clear answers to basic questions such as when and how taxpayers should report gains and losses on digital currency transactions probably encourages tax avoidance.”
Charles Allen, chief executive officer of BitcoinShop Inc., an online marketplace, said he’d like to see the IRS reconsider its decision as virtual currencies develop.
“The implications this decision will have on the Bitcoin ecosystem are far reaching, and will be burdensome for both individual users of Bitcoins, Bitcoin-focused business and for the general adoption of virtual currencies,” he said, adding that Bitcoin users will adapt to the rules.
To contact the editors responsible for this story: Jodi Schneider at email@example.com Don Frederick
Source: Bloomberg.net. “Bitcoin Currency Use Impeded by IRS Property Treatment”. By Richard Rubin and Carter Dougherty. March 26, 2014.
Photo Credit: George Frey. Bloomberg.net.
Tax season is upon us once again and there are a number of tax scams preying upon people’s fears of making a tax return mistake or appeal to their desire to get a bigger refund. Every year, the IRS issues its list of the dirty dozen worst tax scams. These scams appear online, by email and in person. In some cases, taxpayers can’t even trust their tax preparers.
If you become a victim of a scam you can also find yourself in real trouble with the IRS. After the tax con artist has compromised your personal data and taken some, if not all, of your tax refund, you could face significant penalties and interest for not filing a proper tax return or not paying what you legally owe.
Here is a list of this year’s top tax tricks. Pay attention so you do not become a tax scam victim. This countdown concludes with the worst of them all.
Misuse of trusts
Trusts can be valuable legal arrangements to deal with many complex family, financial and tax issues. However, trusts designed solely to hide assets from the IRS are illegal. Beware of a trust that promises to reduce the amount of income subject to tax, offers deductions for personal expenses or claims to lower estate or gift taxes. Trusts can be complicated, so don’t take the word of a stranger offering to set up one that will reduce your tax bill. Find an attorney or other trained tax professional who can help you establish a proper, legal trust.
Abusive tax structures
This is a generally inclusive category for good reason. These types of tax schemes encompass multiple flow-through entities. Basically, reports the IRS, the tax avoidance involves various business arrangements – limited liability companies, limited liability partnerships and international business companies are among the most common – that utilize foreign financial accounts, offshore credit and debit cards, and other similar instruments.
Such schemes are helped by the financial secrecy laws of some foreign jurisdictions and the availability of credit and debit cards issued from offshore financial institutions. The IRS Criminal Investigation Unit targets not only the criminals who set up these elaborate schemes, but also the individuals who knowingly participate in abusive tax schemes.
The IRS refers to various claims to avoid filing and paying taxes as “frivolous arguments.” A popular claim is that return filing is voluntary. It’s not. In fact, the IRS has tougher penalties for not filing than it does for not paying taxes owed.
Then there’s the argument that wages, tips and other compensation received for personal services are not income. Please check the dictionary along with the tax code. Money received via whatever method is income. And it is called an income tax.
Others contend that the United States consists only of the District of Columbia, federal territories and federal enclaves – and only those U.S. citizens must file a return. The states and their residents that receive federal assistance disagree.
These are only a few of the frivolous tax arguments that anti-tax advocates use to encourage taxpayers to avoid filing and paying taxes. The IRS has a 63-page list of them that you should check before falling for these scams.
False income, expenses, exemptions
Most tax cheats report less income than they make, so their tax liability will be less. But in some cases, a taxpayer needs more money to get a tax break’s maximum benefit.
The IRS reports it regularly sees fraudulent income inflating by individuals seeking a refundable tax credit, such as the earned income tax credit, for which they otherwise don’t qualify. Credits prompt such unscrupulous acts because they are better tax breaks than deductions. A deduction lowers taxable income, while a credit lowers the actual tax bill dollar for dollar. Refundable credits, as the name indicates, allows filers who don’t owe tax to get a refund.
Other tax con artists file excessive claims for relatively uncommon tax breaks, such as the fuel tax credit. This is designed to help farmers and, similarly, taxpayers who use fuel for off-highway business purposes.
The key to avoid this common 2014 tax scam is to accurately report your taxable income and expenses. If you don’t, you could face interest on unpaid taxes, penalties that could be as much as $5,000 and possible criminal prosecution.
Bogus charitable organizations
The tax code offers benefits for philanthropic taxpayers. It does not, however, reward those who set up improper nonprofit groups or illegally donate to them. Unfortunately, when bad things happen, bad people take advantage, tax and otherwise. That’s why when there are significant natural disasters, con artists come out in droves.
They impersonate charities to get money or private information from well-intentioned taxpayers. And they use a variety of tactics. Some scammers operating bogus charities may contact people by telephone or email to solicit money or financial information. They may directly contact disaster victims and claim to be working for or on behalf of the IRS to help the victims file casualty loss claims and get tax refunds.
Return preparer fraud
The IRS expects around 60 percent of taxpayers to use tax professionals this year to prepare and file their tax returns. In most cases, those tax return preparers provide honest service to their clients. But, as in any other business, there are unscrupulous tax pros.
Questionable return preparers have been known to skim off their clients’ refunds, charge excessive fees for return preparation services and attract new clients by promising guaranteed or inflated refunds.
Choose your tax pro carefully. Be wary of one who does not have a tax ID number from the IRS.
Other warning signs that your tax pro might not be working in your best interest include a requirement that you split the refund to pay his or her preparation fee, refusal to give you a copy of your return, addition of forms to your return that you had not seen before, and the preparer’s reluctance to put his or her signature on the return.
Changes to tax laws last year reinstated some income-based phase outs of some widely used personal exemptions and itemized deductions, leaving many taxpayers with higher tax bills.
Hardest hit will be those with higher incomes, who will be disappointed to see that deductions they previously claimed on their 2012 tax returns have been reduced or eliminated.
The Personal Exemption Phase Out
Typically tax payers are allowed to claim an exemption for themselves and any other joint filer and dependent on their tax return. The personal exemption is a defined amount – $3,900 for 2013 – which is used to reduce their income before figuring the amount of tax they owe. But starting with 2013 tax returns, single filers with adjusted gross income (AGI) in excess of $250,000 or those who are married filing jointly and have AGI in excess of $300,000 will be subject to a phase out of their personal exemptions.
The phase out of the personal exemption works like this. For every $2,500 of AGI (or portion) above $250,000 ($300,000 for married filing jointly), the $3,900 per-person personal exemption amount is reduced by 2%. For married couples, personal exemptions are fully phased out once their AGI exceeds about $422,000, and for single filers their personal exemptions are phased out when their AGI exceeds about $372,000.
Here is an example of how this might affect a taxpayer:
If you are in the 35 percent federal tax bracket, the loss of each $3,900 personal exemption increases your taxes by $1,365. If you want to know how your tax return is impacted, look at line 42 of Form 1040, to see the amount of the personal exemptions you are allowed to claim on your tax return and compare that to the amount that results by multiplying $3,900 by line six (which is the number of personal exemptions you are allowed to claim.)
Source: CBS Money Watch. ” Disappearing Deductions Cost Taxpayers “. By Ray Martin.
If ever there was a year to look for deductions to your tax bill, this is it. The reason? Millions of Americans will be paying more because of higher tax levels imposed by Obamacare and the ironically named American Taxpayer Relief Act of 2012. But even if you aren’t subject to the higher rates, it still pays to get all the breaks you can.
- PRIVATE MORTGAGE INSURANCE. The home mortgage interest deduction is a perennial favorite of homeowners and while that deduction is now on a phase out schedule for high earners, others may benefit from the private mortgage interest deduction. PMI is an insurance policy that lenders require if you can’t make a 20 percent downpayment on a home. And, 2013 is the last year you’ll be able to claim the deduction unless Congress changes its mind.
You’ll find the amount of PMI you paid on your bank’s mortgage interest form 1098. The break is available to homeowners who took out their mortgage after Jan. 1, 2007.
And, like a lot of deductions, this one has income phase outs too. The sweet spot for this break is an adjusted gross income below $109,000.
- CARING FOR A DEPENDENT PARENT. This is more complicated than it sounds, but if you can claim a parent as a dependent, you can save on taxes. Your parent must live with you and get more than half of his or her support from you. Keep in mind the parent’s earnings must be less than the tax exemption level. The devil is in the details with this one, and you should consult a tax professional. But if you meet the requirements, you’ll be able to claim an added personal exemption on your income tax return.
An added plus, any medical expenses you pay for that parent can contribute to the threshold for deducting medical costs. To meet that threshold, you have to spend 10 percent or more of your adjusted gross income on medical expenses. (That threshold increased from 7.5 percent last year.
- COLLEGE LOAN INTEREST. Parents struggling with the high cost of education will find they can deduct up to $2,500 of annual interest on loans to pay for college. Income phase outs exist, naturally, so high earners might want to consider taking out a home-equity loan instead, which in most cases, will allow you to deduct interest.
- HOME EQUITY LOAN INTEREST. You probably know that mortgage interest is deductible. Interest on mortgage debt up to $1 million is deductible, but phases out at higher income levels. Interest on home-equity loans totaling up to $100,000 also is deductible, no matter what you do with the money.
- JOB SEARCH. If you were looking for a job last year as millions of Americans were, the costs of that job search is deductible. File them under miscellaneous expenses. You don’t have to be successful to claim the deductions. If you do land a new gig, you can also claim relocation expenses for the new job. Consult a pro to determine exactly what you can deduct.
There are more deductions — many more — but you should be aware that some of them are IRS audit bait. Here are a few of the deductions that might get you a second look, if not an audit:
- Home office deductions. This one draws attention especially if you claim a salaried income.
- Non-cash charitable donations, especially if you donate a car to a charity.
- Earned income tax credit. This benefit for low-wage earners is often abused and the IRS will take a close look.
When it comes to deductions, one of the things IRS auditors keep in mind is just how you stack up with other taxpayers. CCH Inc. recently calculated average deductions, and while you shouldn’t use these as a hard and fast guide to your own tax return, it makes sense to have a general idea of what people in your income bracket pay. For example, folks with an income range of $50,000 to $100,000, claim medical expenses of $7,312 interest of $9,320 and charitable contributions of $2,815. These households pay federal taxes of $6,111.
So the point, here, isn’t to discourage you from the taking all the breaks that are due to you. In fact, I say take absolutely everything you are eligible for. The IRS expects nothing less.
Source: Fox Business. “Taking Advantage of Tax Deductions”. By Gerri Willis. March 12, 2014.