Tax day is never over

guest commentary by David Potts

April 15 has come and gone. Thank Goodness! Let’s not think about income taxes for another year. Right? Well, it depends. It depends on how much of your hard earned money you want to give to the government. If you’re interested in keeping more of your money each year rather than paying more income tax, you should always be mindful of the income tax and its affect on your financial transactions.

The people that pay the least amount of tax over time are those that look ahead. Tax planning is about making choices. Should I participate in a qualified retirement plan? Should I buy this new piece of equipment this year or wait until next year? Should I invest in municipal bonds or higher yielding taxable bonds? After Dec. 31 the only choice you have to reduce your tax liability for the previous year (with a few exceptions) is how hard to look for all your receipts.

Let’s look at an illustration. Mr. Jones is 66-years old, retired and receiving Social Security benefits. He worked hard all of his life and saved every penny he could. His wife left him 20 years ago because he wouldn’t spend any money. Once he was wealthy but the majority of his wealth was in the stock market and it’s gone now.  His income in 2009 is expected to be $15,000 of interest income and Social Security benefits of $20,000. He wants to buy a new car this year but wonders whether he should use his savings to buy the car or withdraw $12,000 from his traditional individual retirement account.

If Mr. Jones did not withdrawal any money from his IRA, his Federal income tax would be $473. His taxable gross income would only include $20,000 of interest income. After subtracting the standard deduction and exemption from his $20,000 of gross income, his taxable income is $4,700. Mr. Jones’ incremental tax bracket is 10%. What affect would a $12,000 withdrawal from Mr. Jones’ IRA have on his 2009 tax liability? Several things would change. Mr. Jones’ income tax would increase from $473 to $2,843, an increase of $2,370, or 19.75% of his IRA distribution. But why would his effective tax rate be 19.75% when the tax rate tables show his tax rate on incremental income should be taxed at 15%? His taxable income increased to $21,625 from $4,700, an increase of $16,925. But how could that be if he only increased his income $12,000?

Because Mr. Jones increased his gross income by withdrawing $12,000 from his IRA, part of his Social Security benefits became taxable where previously these benefits were not taxable (before the IRA withdrawal).  As Mr. Jones’ gross income increases, the more of his Social Security benefits become taxable, up to a maximum of 85% of his benefits. This extent of this increase in Mr. Jones’ tax liability was not anticipated. It might be best if Mr. Jones takes less of a distribution from his IRA in 2009 or none at all.

Every year I prepare tax returns where clients engaged in a financial transaction without being mindful of the tax consequences. The consequences of the transaction were costly and unintended. It could have been avoided if they had just asked me, or at least it wouldn’t have been a surprise. If you have a non-recurring or unusual transaction during the year, investigate the potential tax consequences. Start planning now to lower your 2009 income tax liability.

David Potts is a certified public accountant also accredited in business valuation. Owner of Potts & Company, Certified Public Accountants for more than 25 years, his practice focuses on small and medium size businesses and their owners in the areas of taxation, accounting and bookkeeping, business valuation and business advisory services. He is a Fort Smith native and a graduate of the University of Arkansas at Fayetteville. You can follow his blog at ThePottsReport.com.