Preparing for Next Year’s Taxes

Well, it's official; Tax Day has come and gone.  I know I jumped the gun a bit last week, but let's be honest, April 15th is so associated with taxes in the average American mind that who could really blame me?  But by now, you've (hopefully) finished filling out your tax forms and filing them, or at least, gotten an extension on filling them out.  So, what now?

Well, now it's time to consider what you can do to get ready for next year's tax season, of course!  I realize that the memories of filing this year might still have left a horrifying, burning hole in your brain, but trust me, the sooner you get a move on planning for next year, the better off you'll be in the long run.

Here's hoping you had a low enough tax bill that you could pay it with the change behind your couch.

How can you get your financial life in better shape to handle taxes next year?  Well, as you might have come to expect most times when I ask a rhetorical question like that, I do have a few suggestions:

1) Increase the Amount You Put Into Tax-Deferred Vehicles: That is to say, increase your contributions to Traditional IRAs and 401(k) plans (or the equivalent for workers in the government, nonprofit, or self-employed sectors).  As you probably know (particularly if you are a long-time reader or other personal finance junkie), traditional retirement accounts work by deferring your taxes.  You take the amount you donate off of the taxable income amount you report to the IRS for the tax year you make the donation, the money grows untaxed inside the account, and then you pay taxes on the amount you withdraw when you retire, thus deferring your taxes until retirement.

By increasing the amount you put into a traditional IRA or a similar plan, then, you can decrease the amount of income you report to the IRS and thus, the amount of tax you end up paying.  By starting now, you'll have nearly a full year to add money to the account (especially since, as I've noted before, the IRS allows you to make contributions for the previous tax year up to the tax filing deadline), making it that much easier to substantially decrease your tax liability for next year.  Note that if you decide to put money into a Roth IRA (or Roth 401(k), if you are lucky enough to have that option), you won't be able to deduct that amount from your income on your taxes; with Roth accounts, you pay taxes up front and withdraw the money tax free when you retire.  Which option is better is the source of great debate, but if your goal is to cut down your taxes next year, traditional is the route for you.

2) Adjust Your Withholding: When you filled out your taxes, you might have gotten a pleasant surprise; perhaps you discovered that the government had collected too much money from you throughout the year, and that you were owed a refund.  On the other hand, maybe you found yourself owing a sizable chunk of change to the government in order to square up your accounts.  In either event, you didn't hit that sweet spot right in the middle, where you didn't get much (if anything) back, but also didn't owe much.

Assuming your tax situation wasn't something out of Goldilocks (that is, ‘Just Right'), you can fix that for next year by adjusting your withholding.  Simply fill out a new W-4 form with your employer, change the number of allowances you claim (more for a smaller refund and more money throughout the year, and less for a larger refund and smaller paychecks), and violin!  You should have an amount withheld by your employer that puts you right where you need to be, tax payment wise.

Of course, that's not the only option; you need to consider whether you want to receive a large refund or small refund (if not owing money outright), and the corresponding smaller or larger paychecks, respectively.  Personally, unless you have specific and profitable plans for what to do with the boost to your regular income, I would suggest having your employee withhold more money so you can be sure you won't be caught short-handed come next April.  But if you do decide to opt for bigger paychecks and the possibility of owing tax money (and frankly, even if you don't), you should definitely…

3) Build a Tax Reserve: By a ‘tax reserve', I simply mean a supply of money specifically devoted to ensuring that a tax bill doesn't wipe you out.  If you had to pay $3000 this year, and either didn't touch your withholding or increased the allowances you claimed on your W-4, you are likely to pay the same amount, if not more, next year.  Rather than scrambling to come up with $3000 at the last possible minute (and maybe wiping out a sizable chunk of your emergency fund in the process), set aside an extra $250 a month and you'll have the $3000 available next year to pay your taxes.

If you put your tax reserve in a high interest account, like those offered by SmartyPig, amongst others, you can not only keep your money safe, but you'll also get some interest money, as well.  Not much at the moment, I'll grant you, but still, rather than giving the government an interest-free loan for most of the year, you'll be using money you owe them to earn yourself some interest.  (You'll also help to ensure that you don't get caught short-handed, even if the tax rules change and your tax liability increases.)  It's hard to be upset about that.

There you have it, three things to do now that tax season has passed, to help ensure that next tax season will go even smoother for you.  Here's hoping that when you file your 2011 taxes, you'll have a much easier time of it!

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