Life-Changing Events Can Also Be Tax-Changing
Millions of people experience life- and tax-altering events each year. They rarely think about the tax consequences, but experts say they should. For example, when a Santa Barbara couple got married two years ago, they were ready to share a life together. They just weren’t prepared for the tax bill.
They went from getting refunds every year to getting hit with a substantial tax bill for 2004, said Jennifer MacMillan, their Santa Barbara-based tax preparer. That threw their first-year budget for a loop. This year, their taxes are likely to be thrown off again, but in the other direction, because they’ve just had a baby.
Whether it’s a marriage, divorce, birth, death, move or job change, tax experts urge their clients to spend a few minutes each fall to avoid nasty surprises in April.
“I tell people to take a look early so you don’t get behind,” MacMillan said.
What these experts suggest is called a tax projection, and it’s smart to do this now for three reasons.
First, if you discover that you’re underpaying your tax, you can adjust the amount withheld from your pay. That prevents underpayment penalties from the Internal Revenue Service.
Second, if you’ve paid too much, you can reduce the amount of taxes withheld from each paycheck. That could provide better cash flow, so you might be able to make it through the holiday season without leaning on credit card debt, MacMillan said.
Third, if you project your taxes now, you may have time to employ a tax-saving strategy or two, said Philip J. Holthouse, partner with accounting firm Holthouse Carlin & Van Trigt in Santa Monica.
“If you haven’t maximized your retirement plan contributions, you could boost that now,” he said. “That could save you real money next year.”
Tax projections are relatively easy to calculate, particularly in today’s high-tech world. The IRS even offers a free worksheet at www.irs.gov.
How do you do it?
* Assemble records. Pull out a copy of last year’s tax return, your latest pay stub and mortgage statement, as well as property tax and charity receipts.
* Stress test. Take a look at your latest pay stub. It should show not only how much tax you’ve paid in the most recent period but also what you’ve paid year to date.
Now, you want to figure out whether you’re paying too much or too little.
Start by calculating the amount of tax you’ll have paid by year-end. Do this by multiplying your pay stub’s tax payment by the number of remaining pay periods in the year and add that to the year-to-date total. Compare the result with the total amount of federal income tax on last year’s return.
If you’re paying substantially less than last year and neither your income nor deductions have changed dramatically, you’ll want to boost the amount withheld from future paychecks by filling out a new W-4 form with your employer.
If this year’s tax payments will amount to as much as or more than what you paid last year, you don’t have to worry about underpayment penalties, even if you earned far more this year than last, said Irene Lawrence, president of the California Society of Enrolled Agents. They are tax preparers tested on their knowledge of tax law and licensed by the government to represent taxpayers before the IRS.
But if your income has risen -- or if you experienced a life event, such as a marriage, divorce, move or birth -- you may want to project whether you’ll owe money or get a refund in April.
* Project your tax. The easiest way to project how much federal income tax you’ll owe is to use the IRS’ computerized withholding calculator.
To find it, go to www.irs.gov and click on the “Individuals” tab in the upper left-hand corner, then click on the “IRS Withholding Calculator” link halfway down the middle of the page.
There are a dozen questions on the worksheet including how many dependents you have, your income, estimated itemized deductions, the amount of tax paid so far this year and the amount you pay each pay period.
Once you’ve filled out the boxes, click “Calculate” and the site will let you know whether you’re underpaid, overpaid or just right.
* Adjust accordingly. The withholding calculator tells you precisely what to do if you’ve underpaid or overpaid.
In each instance, the taxpayer would need to file a new W-4 form with his or her employer. The website will suggest exactly how.
For example, if you had underpaid by $10,000, the calculator would tell you to claim “0” exemptions on Line 5 of your W-4 and then divide $10,000 by the remaining pay periods in the year.
The result, which is the additional amount that needs to be taken out of each check, goes on Line 6.
If you had overpaid your taxes, the calculator would tell you to boost your exemptions to “32,” which would wipe out further income tax payments for the year.
“Make sure you adjust your withholding again early next year,” said Lawrence, the enrolled tax agent. “If you’re not on top of it, you could end up substantially underpaid next year. That could be a disaster.”
Kathy M. Kristof welcomes your comments. Write to Personal Finance, Business Section, Los Angeles Times, 202 W. 1st St., Los Angeles, CA 90012, or e-mail kathy.kristof@latimes.com. For previous columns, visit latimes .com/kristof.
