An excerpt from The Freedom Formula for Physicians.
Get the last copy of your pay stub. What is your year-to-date compensation? What is your annualized compensation?
Hint: Take your current compensation and multiple it by 12, divided by the number of months already compensated. For example, using an end-of-the-month May check, multiply the amount by 12 divided by 5.
Get the last copy of your tax return. Gather information from the first two pages of Form 1040, Schedule A, and Schedule D. This data will be very important later.
Review the data. How do your wages compare to your AGI? How does your AGI compare to your taxable income? Are you itemizing or taking the standard deduction? How much do you have in exemptions?
Note that Social Security taxes are not usually included here.
What have you learned about your tax situation?
Next, focus on two lines of the second page of the form 1040 of your tax return: line 61 (total tax) and line 72 (total payments). Line 61 will tell you what you owed the government. Line 72 will tell you what you had paid the government.
Were you paying enough to the government or were you paying too much? Going to one extreme or the other could have unfortunate consequences.
I feel that a refund of $1,000 to $2,000 is reasonable. This gives you some cushion. How much of a refund are you getting, or how big a payment are you making?
If you get a large refund ($5,000 and above), you are withholding too much. You are essentially lending money to Uncle Sam for free. I am all for being patriotic, but I won’t lend much money to our irresponsible government. I know it feels good to get a big “paycheck” when you get your refund. But instead, couldn’t you increase your monthly cash flow?
Then you could pay down your debts more quickly, or, perhaps, invest more on a monthly basis.
In order to correct this problem, increase the number of exemptions on your pay stub at work.
Conversely, if you are writing out big checks to Uncle Sam every April, consider decreasing the number of exemptions so that more taxes are withheld. Writing big checks is painful for many of us!
Now that we’ve covered the basics of taxes and how they work, let’s explore several easy ways to reduce income taxes.
Contribute to a 401(k) or 403(b)
I have one basic rule, a mere three words, that I have spoken about in seminars at the Mayo Clinic and with the Minnesota Medical Association time and time again. Pay close attention.
Pay yourself first.
Let’s emphasize this again. Everybody now repeat after me.
Pay yourself first.
This mantra is simple, yet, for many of us, it can be very hard to apply.
First, just simply get started. Contribute to your 401(k) (or 403(b) for nonprofits, e.g., hospitals). It not only counts toward retirement, but it lowers your income taxes.
This money comes right out of your paycheck, withheld by your employer; it never even sees your tax return. This is because the income reported on your tax return is adjusted by these kinds of tax
Think about this for a second. Every dollar you put into your 401(k) gives you a discount on your federal income taxes (but not FICA taxes). For example, if you are in the 25 percent tax bracket, and you contribute $10,000, you have just lowered your taxes by $2,500! That’s like a 25 percent rate of return on your money today that can grow tax-free until you take it out someday when it will be taxed, likely at a lower bracket.
Of course, many of us are actually paying way more than 25 percent, especially when we include state income taxes. We often pay taxes of 40 to 50 percent. That’s an even higher discount on your
Second, at a minimum, make sure to contribute at least up to the maximum match that your employer provides. Your employer’s dollar-for-dollar match is like an automatic 100 percent return. An employer’s match of even 50 cents or 25 cents on the dollar is still like a 50 or 25 percent return, just for contributing.
Altogether, with a match, you may have just doubled your money by being tax efficient.
Lastly, get close to maxing out your contribution in order to lower both your federal and state income taxes. If you are under 50 years of age, the maximum you can put in your 401(k), as of 2014, is $17,500. If you are over 50 years of age, you can make an additional catch-up contribution of $5,500, for a total of $23,000.
Dave Denniston is a professional wealth manager and financial adviser. He is the author of 5 Steps to Get out of Debt for Physicians, The Insurance Guide for Doctors, The Tax Reduction Prescription, and his upcoming book, The Freedom Formula for Physicians.