Most people view filing their federal tax return as closing the books on another financial year. Many don’t realize that reviewing their two-page IRS Form 1040 can provide insights leading to better financial habits and the creation of wealth going forward. Here are nine items to consider:
1. Do you know what tax rate you pay on your income? People may know they are in the 15%, 25%, 28%, 33%, or 35% marginal tax bracket, but don’t realize this isn’t the percentage of their income that they pay to the federal government. A marginal tax bracket is the tax rate applied to the last dollar an individual earned during the year. However, previously-earned dollars were likely taxed at a lower rate. To calculate your effective tax rate, divide line 61 on your 2011 Form 1040 (total tax) by line 22 (total income). This will tell you what percentage of every dollar you earned throughout the year was paid to the federal government.
2. Line 8a is the amount of taxable interest generated during the year. This type of income is usually generated by bank savings accounts or money market accounts. If this figure is too high, you likely have too much of your portfolio invested in cash or have an unnecessarily high emergency reserve fund. Either way, you may be better off shifting some of those funds toward investments that are geared for long-term growth.
3. Line 13 is the amount of capital gains or losses generated by your investments during the year. If this figure is high, it likely means you sold some investments that had experienced significant growth and you may want to review your investment strategy to make sure you intended to. Additionally, remember that capital gains can be offset by capital losses. If a large gain was recognized, it may have been worthwhile to review your investment portfolio looking for losses that could have been recognized to negate the realized gain, thus reducing your tax bill.
4. Line 15a covers IRA distributions. If there is a number here, you may want to look at line 58 to ensure that a penalty wasn’t applied for taking money out of a retirement account before age 59.5. Also, be aware that IRA rollovers don’t count as distributions, so if a rollover was done properly a number should not appear here. Further, while converting a Traditional IRA to a Roth IRA is not a distribution that would appear on line 15a, a taxable amount should appear in line 15b.
5. You may find it interesting to check line 20a and 20b to see how much of your Social Security income is taxable. If you have income from other sources, as much as 85% of your benefit could be taxed.
6. Lines 23 through 35 consist of various deductions you might claim. Review all of these items to ensure you are claiming all the deductions allowed, which will help lower your taxable income.
7. Line 40 clarifies whether you are itemizing deductions or claiming a standard deduction. You should always know whether you have enough deductions to itemize. Itemized (or Schedule A) deductions include some medical expenses, state and local taxes, home mortgage insurance, gifts to charity, casualty and theft losses, and certain job and miscellaneous expenses. Remember, if you aren’t already itemizing, additional Schedule A deductions may not provide an additional tax benefit (unless they push you over the standard deduction amount. In 2012, the standard deduction is $11,900 for married couples and $5,950 for singles).
8. Compare line 7 (total wages) with line 61 (total tax). If you’re paying too much of your wages in taxes, you probably aren’t maximizing contributions to a 401(k) or other retirement compensation plan. Maximizing retirement plan contributions will reduce your taxes and enhance your retirement planning efforts.
9. Lines 62 and 63 are the total amounts withheld from paychecks and the amount of estimated tax payments made during the year. How do these amounts compare with the total tax due on line 61? If not enough money was withheld you could have a large tax bill due at the end of the year and even face a penalty if the gap between taxes due and payments received is too big. However, paying more in taxes than is due is not ideal either. While some enjoy receiving a large refund at the end of the year, there is an opportunity cost to this approach; receiving a large refund means you provided the federal government with an interest-free loan. Wouldn’t you rather keep that extra amount during the year, invest it, and generate a return?
As you can see, reviewing your federal income tax return can provide insights such as whether you should contribute more to your retirement accounts, look for more deductions (such as purchasing a home), change your asset allocation, and more. Ask your tax professional if you have questions on these subjects.
Bonus: President Obama’s Tax Return
Curious whether President Obama has his financial ducks in a row? Click here to view his 2010 tax return. While some lines are slightly different than the 2011 version of IRS From 1040, you’ll get the point. You can see from line 22 that total income was $1,795,614, which would put him in the 35% marginal tax bracket. You can also see on line 60 that his total tax bill was $453,770, meaning his effective tax rate is about 25%. He has only a small amount of his income coming from taxable interest on line 8a, so the majority of his money is likely invested in more long-term assets. He claimed a capital loss of $3,000 on line 13, so he is likely harvesting his investment losses to offset his gains. On line 28 we see $49,000 were contributed to qualified retirement plans (he most likely contributed the maximum amount allowed to a SEP). On line 40 we see he had an incredible $373,289 in itemized deductions. Finally, on line 73, we see he over-contributed $12,334 in taxes during the year – probably reasonable given his large tax bill. Overall, as you would expect, it looks like the President handled his finances relatively efficiently over the course of 2010.