How to Plan for the IRS to Improve Your Credit - dummies

How to Plan for the IRS to Improve Your Credit

By Steve Bucci

Okay, planning for the IRS may be like planning for the dentist, but pretax flossing and brushing make this unpleasant subject a lot easier to swallow. Without getting into Novocain-like numbing details, you’re better off if you look at this issue as an important component of your spending plan.

Why? Because if you owe tax money, if you’re counting on your tax refund to fill out your budget, or if you’re considering bankruptcy, then drilling down into this subject can save you from a financial toothache.

Typically, you pick a number of deductions and your employer withholds money from your paycheck and sends it to the IRS. The deductions reflect an estimate of what you’ll owe, but most people end up either owing too much to the government on April 15 or getting too large a tax refund.

Not all income is subject to withholding. Among the exceptions are dividends, interest, income from side businesses or hobbies, tips, investment gains, gambling winnings, money paid to you as an independent contractor, small-business income, forgiven debts, rents, and gifts above a certain dollar amount. But that doesn’t mean you don’t have to pay taxes on that income! Know what you owe, and prepare yourself for that inevitability.

As you do your planning, you can choose one of three approaches:

  • Overpay

  • Underpay

  • Strive to pay just the right amount

You can probably guess which strategy is the right one.

Overpaying your withholdings

Many people tell me, “I don’t want to owe any money,” or, “I use my refund to pay down my credit cards after holiday shopping,” so they deliberately overpay their taxes as a budget-balancing/forced-saving strategy. But overpaying is too hard on your budget.

At a minimum, you’re giving the IRS an interest-free loan that you could be using to pay down your debt, build up savings, or achieve any other good purpose. If you’ve overpaid all year and an emergency comes along in November, you can’t ask the government for an advance of your refund to cover it. But you could use that money if you had it in a savings account.

If you’re consistently getting a refund check, go over your situation with a qualified tax preparer. You can likely find a better way not to owe on April 15 without overpaying every pay period.

Underpaying your withholdings

A too-soft approach to taxes ends with a nasty surprise. If you under-withhold and owe a big tax bill in April, you may find your credit cards absorbing even more unplanned expenses, including tax penalties, interest, and a fat convenience fee. Ouch! Plus, your cards may well be full already.

Most local, state, and federal taxes usually can’t be discharged in a bankruptcy, nor can credit card debt incurred from paying your taxes.

Paying just what you owe

Oh, this feels just right! Adjusting your withholdings so you either give a little or get a little is not as difficult as it may seem.

You may be surprised to discover that you can have more deductions than you have people in your household. It’s true. Adding the cat as a dependent isn’t recommended, but a deductible mortgage payment can count as one or two additional deductions.

Consult with a tax preparer to get a good forecast of your tax commitments for the year. You may get an early budget bonus if you find that you’re over-withholding and can decrease your deductions, which may enable you to fund some of those short-term goals you’ve been saving for.

On the other hand, if some nasty bears are in your future, you’re much better off knowing about them in advance so that you can be prepared and not be caught asleep when they come in the front door.

The right amount isn’t a precise number. Until all the figures are in, there’s no way to know exactly what you’ll owe. Consider padding your estimates of what you’ll owe in April by $600 to $1,000. An amount of $50 to $80 a month won’t make a big difference to your monthly budget, and as long as your income is relatively stable, tax time may be a breeze.