Sunday, January 11, 2009

Making money means planning for income taxes

We'll talk about the markets in our next post. When you either have your first job or income producing business, you must plan for income taxes. In a business setting, most states require payment of estimated taxes on sales on a monthly basis. The money is due between the 16th and 20th of the month and they don't accept excuses for late filings.

When you get your first job, if your employer asks you to fill out a W-4 withholding form, you usually want to claim "2 exemptions" on the federal form AND "2 exemptions" on the state form if you reside in one of the 43 states that has a state income tax. The reason for "2 exemptions" because you are likely single when you have your first job and you want to make sure that you withhold just enough to comply with the laws but no so much that you get a refund. When you hear about your friends getting big four figure refund checks every year they are giving the government an interest free loan on their money.

By filing "2 exemptions" on both federal and state, the most common scenario is that you will owe a small amount of money both the federal and state governments every April 15th. If you don't have any capital gains from stock transactions, you want to make sure that your withholding payments equal 90% of your estimated total taxes.

If this all sounds confusing, it's actually very easy. When you get your first paycheck, if you work a standard 40 hour week you can take the amounts listed on each line and multiply by the number of pay periods you are paid by this company. Then you can pull up the income tax tables on the or the local state department of revenue and do a quick calc on whether you might pay too much or too little in taxes.

If this all sounds confusing, you can always give me a call, but there is TurboTax and I'm sure by the time you are reading this, the calc is probably available as freeware over the internet.

Because I had a big capital gain in 2007, I was probably subject to estimated tax in 2008, so I had to make estimated payments on 4/15/08, 6/15/08, 9/15/08, and 1/15/09. Because my income fluctuates depending on how I do in the markets, I made very small payments for the first three dates otherwise I would have ended up overpaying in taxes. However, the past three months have been pretty good, so I have to up the final payment a little to make sure that 1) all my withholding payments from my job plus 2) the four estimated tax payments on 4/15, 6/15, 9/15, and 1/15 total 90% of the tax calculated for the entire calendar year. The other wrinkle is that the state I reside in, the remaining amount owed must be less than $200. So even if I pay 90% of the estimated tax liability since I won't know the final numbers until all my sources mail their 1099 forms on January 31 and it arrives around the first week of February, the amount owed on 4/15 must be less than $200 for the state I reside in; otherwise the state will charge an underpayment penalty. The federal form is more conservative as all they care is 90% paid regardless of the final 10% is over $200.

Estimated taxes only occur when you owe more than $1000 on 4/15 or if you expect that your withholdings are less than 90% of the final bill. The first year it happens, you usually get a free pass, but the government expects you to start paying estimated taxes. So let's say you owe at least $1000 in 2007 and the amount is due 4/15/08. Well you also have may have to send two additional checks to the state and federal government on 4/15, 6/15, 9/15, and 1/15/09 because that is the way the law is written.

Tax law is not as complicated as your friends want to make it. If you are as responsible with your money as your parents, you have the ability to manage your money as wisely as them. All you have to learn is adding a few extra payments to the government when you are making money.

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