It’s that time of year again – tax time! Filing your taxes can be stressful and confusing. You might not be sure what information you will need, if you are doing it right or even worse, if you will end up owing the IRS money.
While what I share with you might take some time, if you follow these five steps, you will feel confident about the tax prep process. Pay special attention to the fifth step because it will make your life easier and less taxing (pun intended) in the years to come.
Step 1: Gather important information.
In order to file your taxes, you or your tax accountant will need to have some specific info handy.
Step 2: Compile your income information.
Next, you will gather all information and corresponding documentation relating to your income. This forms the basis of your tax bill. If you work for a company, you will receive a W-2 Wage and Tax Statement with all of your necessary wage income information. If you are an independent contractor, you will receive a 1099-MISC form from companies that pay you.
Your wages are not the only income that’s taxable. You will also be taxed on income you earn from interest on savings. Each of your accounts will have a 1099-INT form available with your annual interest income. If you own stock or mutual funds, you will also find a 1099-DIV form that shows the income you earned from dividends (i.e. payout from companies that you receive as an investor). You will pay tax on this income as well.
Selling a security will also affect your tax bill in the form of a realized gain or loss. When you lose money on an investment, this reduces your taxable income and therefore decreases your tax bill. When you make money on an investment, this increases your taxable income and therefore increases your tax bill. The gain or loss is the difference between the price you sold the investment for and the price you bought it. If the investment increased in value, you realized a gain and if it decreased in value, you realized a loss. You can find this information on a 1099-B statement from your broker or brokerage firm. If you haven’t sold any investments, you haven’t realized any gains or losses. If an investment you own goes up in price and you haven’t sold it yet, that’s considered an unrealized gain and you don’t have to pay taxes on any unrealized gains or losses.
Tax tip: One way to minimize the taxes you pay on realized gains is to hold onto an investment for at least a year before selling it. If you buy and sell an investment in less than a year, you will be taxed at the same rate as your ordinary income. If you buy and sell an investment a year or more after buying it, you will then be taxed at the long-term capital gains rate which was 15% for 2015. This can significantly reduce your tax bill.
Step 3: Trim your tax bill.
Now you can work to trim your tax bill so that you do not over-pay in taxes. This is where tax deductions come into play. Put simply, a tax deduction is just a reduction of your income that is able to be taxed.
Here are some items that are tax-deductible:
There are many more tax deductible items that may apply to you and your life. If you are ever unsure, contact a tax professional or even do some online research to find more information. We don’t want to miss out on any mone saving deductions!
Tax tip: There is a popular misconception that deductible expenses are essentially free. For example, a self-employed person may take taxis from meeting to meeting more often because they know these types of expenses are tax-deductible. I recommend thinking of deductible expense items the same way you would think about something on sale. Yes, you are receiving a discount but if you weren’t going to spend money on that item anyway, you aren’t saving any money!
Step 4: Document your business expenses.
If you are self-employed, you will want to keep track of your business expenses as well as the bills or receipts that go along with those expenses. What’s a deductible business expense? According to the IRS, deductible business expenses must be ordinary and necessary, meaning they are helpful and appropriate for your trade of business. Expenses don’t have to be indispensable to be considered necessary. You can learn more about which expenses are deductible, how to categorize them as well as how to deduct the business use of your home and car at the deducting business expense page of the IRS website.
Step 5: Create a system for next year.
If you waited until the last minute to go through steps 1-5, it most likely took you some time. You probably had to rack your brain to remember what you were spending in January of last year and search through old emails to find proof of your donations. Make your life easier this year and create a system so you are gathering the necessary information year round. You may want to track deductible expenses and business expenses each month. Take photos of important receipts or keep hard copies in a certain place so that you know where to find them when it’s time to do your taxes. Don’t let your money meeting get pushed off each month. Decide on a day that’s most convenient for you and put it in the calendar. It can also be helpful to find a resource like a tax preparation checklist to help you track what you need.
Avoid the tax filing frenzy using these five steps so that you have all the information necessary to file when the deadline comes around. Then, put together a plan to make tax season less stressful in the coming year. No need to come up with a complex system. A small step in the right direction works wonders!
A version of this was posted originally in Military Transition News.