Q&A - Income Tax Refunds


Topic:   Income Taxes

Q:  We typically receive a large income tax refund every year.  We don't really mind this because we probably wouldn't save the money otherwise.  We're told all the time that this is a poor way to plan.  What are your suggestions?

A:  Each year, millions of taxpayers receive tax refunds, often $1,000 or more.  One way to look at it is you are getting a bonus or it's a form of forced savings.   But another way to look at it is you have lent the government money interest free over the past year.  Consider reducing your withholding and invest the extra take-home pay.

While we're on the subject, the experts here at FPA-SEWI would like to point out some other common mistakes to avoid that will help consumers possibly put some more money in their pocket.

Failure to plan ahead.  It's almost too late to do much for your 2001 return, but now is an ideal time to start planning for 2002.  Many strategies to lower tax liabilities must be taken during the tax year, not after the tax year is over.

Poor record keeping.  Incomplete or disorganized financial records can lengthen the time it takes to prepare your tax return, boost the cost of having a professional prepare your taxes, or cause you to miss out on valuable tax deduction because you overlooked or can't support the deduction.

Failure to contribute to a tax-deferred retirement plan.   Investing in a tax-deferred retirement plan is one of the best tax tools available.  It not only lowers your immediate tax bill, it helps you build a bigger retirement nest egg.   Yet 34% of eligible workers don't participate in one of the more popular forms of retirement plans, the 401(k).

Wrong investment basis.  2002 was a rough year for many investors, and you may have sold shares in one or more mutual funds.  You'll pay the taxes on the difference (capital gains) between what you invested in the fund (cost basis) and what your sold it for.  What many taxpayers forget, however, is to include their reinvested dividends and capital gains as part of their basis (distributions are taxed separately).  Apply this same rule if you own stocks with automatic reinvestment of dividends (DRIPs).

Wrong inheritance basis.  Another common tax mistake involving investment basis occurs when people sell inherited property.  If your aunt bought stock for $10,000, passed it on to you at death valued at $50,000, and you sold it in 2001 for $60,000, you pay capital-gains tax only on the $10,000 difference between the $50,000 and $60,000-not on the $50,000 difference between your aunt's purchase price and your selling price.  The basis for inherited property is pegged to the value of the property at death.

Failure to bunch deductions.  Here's where long-term tax planning comes in.  To itemize some deductions, you must exceed certain thresholds (7.5% of adjusted gross income for out-of-pocket medical expenses and 2% for miscellaneous deductions).  Try to bunch as many expenses in one year so you can deduct the amounts that exceed the thresholds (this strategy can actually increase taxes for those in higher tax brackets or subject to the alternative minimum tax).

Even deductions that aren't subject to thresholds can contribute to a bunching strategy.  Real estate taxes, charitable contributions, and, to some extent, state income taxes can be bunched into alternate years.  In the intervening years, take the standard deduction.   This strategy allows you to take full advantage of all your itemized deductions plus what amounts to half of the standard deduction over every two-year period 

Overlooked charitable deductions.  Most of us claim cash and property donations, but often overlook mileage, parking fees, postage, or long-distance phone calls associated with doing charitable work.

Forget to claim deductions carried over from previous years .  Some deductions may be claimed this year if they were carried over from previous tax years.  These include capital losses, passive losses, charitable deductions, and alternative minimum tax credits.

Failure to deduct refinancing points.  If you refinanced in 2001, you can deduct a portion of the points (prorated over the life of the loan).

The little things.  Double check your math, use the correct tax table, and sign the return.