Understanding tax system first step toward financial fitness

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With tax season here, it’s time to balance the annual equation of income taxes owed and income taxes paid.

A Morgan Stanley advertisement said, “You must pay taxes. But there’s no law that says you gotta leave a tip.”

Understanding how the federal tax system works and how much tax is owed is the first step toward balancing the equation and the start of a financially fit new year.

At one point in time, early in your career, you filled out an Employee’s Withholding Allowance Certificate Form W-4 informing your employer how much federal income tax you desired withheld from each paycheck. The worksheet takes into account personal allowances such as if you are married or single, have dependents and current income levels. The amount of income tax withheld from each paycheck is determined by the number of exemptions stated. If the annual tax amount withheld is more than the taxes you owed, you receive a tax refund. If you owe more in taxes than was deducted, you will need to pay the additional amount owed. Every year the income tax equation is balanced.

If you receive between $0 and $500 per year back in a tax return, this indicates that your exemptions are right where they need to be for your income level and personal allowances. However, anything more than $500 or if you find yourself paying more than $500 each year, you might want to re-examine the amount you are having withheld in taxes.

Every year I speak with clients who are expecting a nice, big tax return check. A few clients say they will use the money to pay off credit cards, put it in savings or perhaps pay down a car loan, but more often than not the check is spent on an unplanned European vacation or a large screen television. The windfall of money is spent as a bonus check and not as hard-earned income. Let’s say instead of receiving the $1,200 tax refund check, you chose to adjust the Form W-4 so less taxes were withheld each month. Furthermore, let’s say during a four-year enlistment, you chose to invest the $100 a month earning a 5 percent return. At the end of a four-year enlistment period, you could have an investment balance of $5,324.

Benjamin Franklin said, “In this world nothing can be said to be certain, except death and taxes.” This statement may be true, but understanding the federal income tax system and current withholdings may expose money available to invest in a better financial future. n