Taxes are tough. It seems as if you're constantly paying them -- sales tax here, withholding tax there, income taxes everywhere. Just when you finally get through dealing with one tax, another tax rears its ugly head; and like clockwork, when you're done with all the taxes, it's time to start over and deal with them again. It's enough to drive you mad.
So if an article were to tell you to start thinking about your 2006 income taxes -- the ones that aren't due until April 15, 2007 -- you'd probably just laugh and say that you'll get to it in all that free time that you don't have, or at the very latest, after you get around to filing the 2005 taxes that you still have on extension.
But that's exactly what this article is telling you.
With half the year over, it's a great time to look over how you're doing on your taxes, and to take steps now to prevent any ugly surprises further down the road. With just a few simple tips, you can not only feel more secure about your taxes now, but also make your life a lot easier when next April rolls around.
Checking your withholding
The biggest component in determining whether you'll get a refund or owe tax at the end of the year is how much you have withheld from your paycheck. You may vaguely remember the form that your personnel department gave you when you started your job; you counted up a bunch of numbers, added everything together, put a number in a box, signed the form, and promptly never thought about it again.
The problem with that form, called a W-9, is that it doesn't give you a good indication of how much money will actually be withheld from your paycheck. Instead, the form asks you for some information about yourself, and then basically expects you to take on faith that when you put the corresponding number on the form, it will produce the withholding result that you want. The first time you really have an idea of what things are going to look like is when you get your first pay stub that shows the itemized breakdown of your pay and deductions from it.
One easy way to see how you're doing is to take your pay stub from your June 30 paycheck (or whatever your closest payday is to June 30) and look at your year-to-date numbers. The numbers to look at for these purposes are your gross pay, minus any deductible items such as 401(k) contributions and medical plan payments, and your federal tax withheld. For most people, you can simply multiply your June 30 numbers by two. That should give you a good idea of where you'll be at the end of the year.
From here, there are two things you can do. The simple thing is to get out your tax return from last year and compare your wages and withheld taxes from last year to the numbers you just calculated for this year. If the numbers are roughly the same, and if last year your withholding worked out well for you, then you're probably OK. But if your income is a lot higher this year and your withholding hasn't kept pace, then you may need to take a closer look.
The more precise way to see if you're having enough money withheld from your paycheck is to use the form for estimated taxes, Form 1040-ES. This form will have you plug in not only your wage income but also any other types of income, such as investment income. The nice thing about this form is that even though it takes a bit more work, it gives you an actual dollar figure at the end that you can use to figure out how to change your withholding if necessary.
Investment income and capital gains
The wage withholding tax system isn't really set up to deal with people who have significant income other than wages. As a result, you should monitor your investment income and capital gains closely to make sure that you won't get hit with an unexpected tax bill at the end of the year.
Most brokerage and mutual fund statements have information about year-to-date income. So when you get your second-quarter statement at the beginning of July, it should let you know how much you've earned in the first half of the year. Unfortunately, if you own mostly mutual funds, you can't just double this number, because many mutual funds pay out the bulk of their income toward the end of the year. However, if the number appears bigger than last year's, you may end up owing more tax.
Similarly, if you've sold some investments at a gain, the resulting capital gains may have a big impact on your taxes. Identifying the potential effect while you still have six months to find losses to offset gains or take other action is far easier than waiting until the last minute.
Don't forget deductions
Deductions have just as much impact on your final tax bill as income does. Therefore, in order to get a complete picture of where you stand, you should look not only at income but also at the expenses you deduct. If, for instance, you had new deductible expenses for the first time this year, such as mortgage interest on a new house or large medical bills, then your deductions may be higher, lowering your tax. Similarly, if you had some big expenses last year that didn't carry over into this year, then your taxable income may well be higher.
Paying tax isn't bad
Although it's nice to get a refund check at tax time, remember that your refund is your money that you lent to the government, interest-free, for a year or more. From a pure financial standpoint, it's best to pay as little tax during the year as possible, holding out until the bitter end on April 15 -- as long as you avoid any penalties for not having enough tax withheld. The general rule is that if your withholding is at least as much as your actual tax due was on last year's return, you won't owe a penalty, no matter how much you owe this year.
The key is to remember that you're going to owe that money on April 15. Keep it available somewhere it can earn interest, but make sure it's earmarked for your income taxes.
Dealing with your taxes is a big challenge. Like many things, however, if you stay on top of your taxes with some pre-planning, it's a lot easier to keep them under control.
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Fool contributor Dan Caplinger welcomes your comments.
