Financial Q&A: Tips to Pay Less Tax or Get a Bigger Refund
Laura answers tax questions from readers, listeners, followers, and group members that will help you understand how to pay less tax, defer it, or to boost your tax refund and save more money every year.
You can’t avoid taxes, but there are many ways to legally pay less so you keep more of your hard-earned money.
In this post, I’ll answer some common and not-so-common questions about taxes from Money Girl readers, podcast listeners, Twitter followers, and private Facebook group members. This Q&A will help you understand how to pay less tax, defer it, or boost your tax refund every year.
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Question #1: Chesley says, “My W-4 says that I’m married, but I’ve actually been divorced for a few years. Is it important to update that—or is the status I put on my tax return what really matters?”
Answer:
The filing status you enter on your tax return is what’s most important because it determines how much tax you’ll owe. However, if you’re an employee, you should update your W-4 any time you have a life change, such as getting married or divorced, having a child, or earning more or less income. In fact, the IRS says you’re supposed to make W-4 updates within ten days after a major life event.
The amount of tax your employer withholds from your pay depends on your income and the information you submit on your W-4, such as your marital status and how many allowances you have.
If your W-4 doesn’t accurately reflect your situation, you could have too little or too much tax withheld. Not paying enough means you could get a big, unexpected tax bill. Or, if you overpaid during the year, you’ll end up with a tax refund.
While a refund sounds good, it simply means that you gave Uncle Sam an interest-free loan on your money throughout the year, instead of using it for your own good.
So be sure to adjust your withholding if you get big tax refunds every year. That’s an easy way to give yourself a raise! Save or invest the money instead of letting the government use it.
However, your withholding typically won’t be correct down to the penny. That’s because the worksheets don’t account for every possible situation, such as having additional taxable income from interest, dividends, alimony, unemployment compensation, or self-employment income.Â
You can update your withholding anytime during the year by completing IRS Form W-4opens PDF file and submitting it to your employer. If you need help, use the IRS Withholding Calculator or ask your human resources or payroll department.
See also: What Is the Marriage Tax Penalty?
Question #2: Penny from my Dominate Your Dollars private Facebook group says, “Can you use a kid’s chore money to fund a Roth IRA on his or her behalf?”
Answer:
This is a common question because the rules for contributing to a traditional or a Roth IRA say that you can have one at any age. So it seems like a child could qualify for an IRA if they earn an allowance, have baby-sitting income, or get cash gifts from grandparents on holidays.
But it’s not quite that simple because the IRS says you must have taxable compensation during the year to qualify for an IRA. That means you have to prove it by being employed and receiving a W-2 or by filing taxes on business income. You can’t double-dip by not paying tax on income to begin with and also sheltering it from additional tax inside an IRA.
If a child provides services like baby-sitting, mowing lawns, or doing household chores, that qualifies him or her as being self-employed. But you have to report their net earnings by filing Form 1040opens PDF file and submitting either Schedule Copens PDF file or Schedule C-EZ. Plus, if a child has over $400 in net earnings, you must also pay the self-employment tax by submitting Schedule SEopens PDF file .
So, you’re going to need to keep careful records about revenue and expenses for each job that a child has and pay tax on his or her net profit. For instance, if a child makes $2,000 this year moving lawns for neighbors, and pays $300 to service the lawnmower, her net earnings are $1,700. If they are properly reported, she would be eligible to contribute up to $1,700 in either a traditional or a Roth IRA this year.
Let’s say your son earns $3,000 working a summer job as a bus boy in a restaurant. As long as his W-2 reflects that income, he’s eligible to contribute up to $3,000 in an IRA. Â
But what if he spends all the money or wants to save it to buy a car? His money doesn’t have to be used to fund the account. As long as a child has taxable earned income, you (or anyone else) can fund an IRA that’s in your child’s name on his behalf.
As long as a child has taxable earned income you (or anyone else) can fund an IRA that’s in your child’s name on his behalf.
However, you can’t contribute more than his actual earnings, which is $3,000 for the year in my last example—even though the maximum IRA contribution for 2016 is $5,500.
Not all investment companies allow minors to open up an IRA—but don’t let that stop you because there are plenty that do, including:
Question #3: Mark says, “I have a new health savings account (HSA) and will max it out this year, in addition to fully funding my retirement accounts. But I rarely have medical expenses, so should I just treat the HSA like another tax-advantaged retirement account? Also, can I make a prior year contribution for 2015, even though the account wasn’t open until 2016?”
Answer:
I like the way Mark is thinking because he’s making the most of every tax-advantaged account he can get his hands on!
The beauty of an HSA is that you can use it to pay for qualified medical expenses on a tax-free basis—but you never have to spend the money. That’s right; you can max it out every year and the growing balance simply rolls over from year to year without penalty.
Unlike a flexible spending arrangement (FSA), there’s no deadline to spend the money in an HSA. Even if you cancel your high deductible health plan (which is a requirement to open up and contribute to an HSA), you can still use HSA money indefinitely to pay for medical expenses tax-free.
Just be sure that you won’t need to tap the account, because if you spend HSA money on anything other than qualified medical expenses, and you’re younger than age 65, you must pay income tax plus an additional 20% penalty on the amounts.
If you’re like Mark and anticipate still having funds in an HSA in the future, that’s fine because it morphs into something like a retirement account. After you turn 65 you can spend HSA money for non-medical expenses without penalty. However, you do have to pay ordinary income tax on those amounts, which is similar how it works when you take distributions from a traditional IRA in retirement.
So the answer to Mark’s question is that treating an HSA like a retirement account is that it’s a great strategy. It’s there for you if you have medical expenses, but you’re not penalized if you don’t use it.
When you initially open the account, you can only make contributions for the current year, not a prior one. Plus, you can’t use HSA funds to pay for a medical expense you incurred before the account was officially open. For instance, if you open and fund an HSA in January 2016, you can’t use the money to pay for a medical procedure that you had in the fall of 2015.
For 2016, if you have a high deductible health plan, you can contribute up to $3,350 to an HSA for an individual policy, or up to $6,650 if you have a family policy. If you’re over age 55, you can contribute an additional $1,000 to an HSA when you have either type of health plan.
See also: How to Save Money on Healthcare with an HSA
Question #4: Mike says, “I recently changed jobs and my new employer doesn’t offer health insurance for 90 days. Besides putting myself in financial risk, are there tax consequences if I don’t have coverage during the waiting period?”
Answer:
The Affordable Care Act, known as Obamacare, requires every American to have health insurance no matter your age, income, or employment situation.
If you don’t have coverage, you typically have to pay a penalty that’s collected by the IRS. It’s calculated in 2 ways: a percentage of income and a flat fee. You have to pay whichever is higher.
The penalty rates have increased by set amounts over the past few years and will be adjusted for inflation in the future. For 2016, the Obamacare penalty is 2.5% of annual household taxable income or a flat rate of $695 per person.
However, there are some exemptions and hardships that allow you to legally avoid the penalty. One of them is having a short lapse of coverage that’s no more than 2 consecutive months. You’re considered covered even if you had a qualifying health plan for 1 day during a month.
For example, if you didn’t have coverage from January 2 to April 15, your coverage gap was only two months, February and March. You’d qualify for the exemption and not have to pay a healthcare penalty.
But if Mike’s gap is a full 3 months or more, he’ll have to pay a penalty for every day that he’s uninsured. And, as he mentioned, going without a health plan is dangerous for your physical and financial well-being.
To know how the Obamacare penalty will affect your taxes and if you qualify for an exemption, check out the H&R Block ACA Tax Calculator at hrblock.com. You can shop and compare health plans by starting at healthcare.gov.
See also: What Is Obamacare? 8 Facts You Should Know
Question #5: Tammy says, “I recently inherited $25,000 and want to invest it in a 401k. What are the tax consequences of doing that?”
Answer:
In order to have a 401k, you must be employed by a company that offers it or be self-employed and set up a solo 401k for yourself.
In order to have a 401k, you must be employed by a company that offers it or be self-employed and set up a solo 401k for yourself. Since Tammy didn’t mention her employment status, I’ll cover both options.
If you can participate in a 401k at work, your contributions can only come through payroll deductions. In other words, you can’t just make a lump sum deposit directly into a workplace plan, like you can with many other types retirement accounts.
Once you’re enrolled in an employer’s 401k, you can typically contribute as much as 90% of your paycheck to the plan. For instance, if your gross pay is $1,000 you could elect to contribute $900 to your 401k.
For 2016, the most you can contribute to a 401k is $18,000 or $24,000 if you’re over age 50. So depending on her age, Tammy could invest $25,000 through payroll deductions over a year or two. She would contribute as much as possible from her paycheck and then use her inheritance to pay the monthly bills.
If Tammy doesn’t have a job that offers a 401k, she could invest her inheritance in a traditional or a Roth IRA. However, for 2016, the most you can contribute is $5,500 (or $6,500 if you’re over age 50). So it would take her a few years to fully invest the entire $25,000.
The other option I mentioned is called a solo 401k, which is a plan Tammy can use if she’s self-employed (on a full-time or part-time basis) and has no employees other than a spouse. If she does have employees, a good option would be to invest through a SEP-IRA.
The tax consequences of investing through a 401k, or any type of retirement account, are terrific because you cut the amount of tax you have to pay and save money. Traditional accounts give you an upfront tax deduction in the current year and allow you to avoid all taxes until you take withdrawals in retirement.Â
On the other hand, Roth accounts require you to pay tax on your contributions in the current year, but allow you to take withdrawals of contributions and earnings in retirement that are completely tax free.
The only downside is that if you want to take money out of a retirement account before reaching the official retirement age of 59½, you may have to pay income tax plus a 10% early withdrawal penalty.
See also: 5 Retirement Options When You’re Self-Employed
Question #6: Anita says, “I’ve been contributing to a flexible spending arrangement (FSA) for years and am starting on a high deductible heath plan with an HSA. Is it true that contributions to these types of accounts reduce your Social Security earnings for the year and therefore your benefits in retirement?”
Answer:
Different types of deductions employers take from your paycheck on a pre-tax basis are handled in different ways. Some reduce all of your taxes, which include:
- Federal income taxÂ
- State income taxÂ
- Social Security taxÂ
- Medicare tax
And some reduce your federal and state income taxes only. The most common payroll deductions are for 401k contributions. They reduce your income taxes only, which means you still have to pay Social Security and Medicare taxes on your gross earnings.
By the way, Social Security and Medicare taxes are collectively known as FICA (Federal Insurance Contributions Act) taxes and are split 50-50 between employers and employees.
Anita is correct in saying that deductions from your paycheck for FSA or HSA contributions are generally not subject to any payroll taxes. That means you save money on taxes, including Social Security and Medicare.
However, FSA and HSA contributions also lower the earnings that are reported to the Social Security Administration for purposes of calculating your future retirement payment. That means your future Social Security benefits may be slightly reduced if you participate in an FSA or an HSA.
While FSA contributions are always made through employer payroll deductions, you can contribute to an HSA on your own and then take a deduction for your total annual contributions when you file your taxes. That’s the best way to handle HSA contributions so you continue to pay into Social Security. However, that’s not an option when you participate in an FSA.
Bonus Question:  Twitter follower @teeairawr says, “A good topic for your podcast would be tips on how to maximize your tax refund.”
Answer:
Fortunately, there are many ways to cut your taxes so you pay less or get a bigger tax refund.
One is to maximize your tax deductions, which reduces your taxable income and therefore the tax you have to pay. Get familiar with the complete list of deductions on Schedule Aopens PDF file . They include medical expenses, having a home office, home mortgage interest, and making charitable donations.
Another tip to pay less tax is to defer or delay it when possible. You can use traditional retirement accounts (such as a traditional IRA or 401k) to defer tax on contributions and earnings in the account until some time in the future.
So make a goal to increase your retirement savings every year. Also, don’t forget that if you’re married and don’t work, you can still have a spousal IRA if you file taxes jointly.
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About the Author
Laura Adams received an MBA from the University of Florida. She’s an award-winning personal finance author, speaker, and consumer advocate who is a frequent, trusted source for the national media. Money-Smart Solopreneur: A Personal Finance System for Freelancers, Entrepreneurs, and Side-Hustlers is her newest title. Laura’s previous book, Debt-Free Blueprint: How to Get Out of Debt and Build a Financial Life You Love, was an Amazon #1 New Release. Do you have a money question? Call the Money Girl listener line at 302-364-0308. Your question could be featured on the show.
