One friend's strategy: Open an IRA to reduce taxes

My taxes and I get along quite well, usually getting a refund back more than having to pay to the government. (I do try not to get refunds, but so far, not quite there.) However, not everyone is so lucky. One of my friends found that when she figured her taxes for 2009 that she owed more than she wanted. Of course, she had waited until April 10 to calculate what she owed the various governments (she and her husband work in two different states). Currently, she and her husband rent, have one child and are resident aliens. However, when she calculated what they owed, she was not pleased with the total. In fact, she told me she was opening a traditional IRA to reduce her tax burden.

I can only speak in general terms because I do not know how much she owed or how much her tax bill was reduced by opening and contributing to an IRA. However, she reduced it enough that the refund from the state covered what she owed to the federal government with a small amount left over. I have not gotten to this point, but I know this is one strategy to reduce tax burdens rather quickly especially as in my friend's case, taxes are not figured until the last minute. This may be why people can contribute to a Roth or traditional IRA until April 15.

Our tax situations are different. I am single, have a house with a mortgage interest to deduct, contribute to charity and to my 401(k). She is married with a child, rents her home and contributes to her 401(k). To further reduce her taxes, she plans on continuing to contribute to the traditional IRA and possibly opening a 529 for her child.

Is contributing to an IRA a tax-reduction strategy you could use?

An early bonus

My recent payroll check had a small surprise in it: my extra exemption came through. To be honest, I was surprised my withholding had already been adjusted as I submitted the paperwork only a week before the end of my pay period, but there it was--a little extra money. In the end, one extra exemption meant $22 more in my paycheck. I had estimated I would receive about $20 so I was pleased to see my estimate was close to reality.

As I discussed in my earlier post, I planned on using the extra money toward my Roth IRA. However, I chose to use only $21 per paycheck for a Roth IRA contribution. Based on my biweekly check and monthly contributions, this number worked out better than $20 or $22. The extra $2 per month is added to my farm account. As of writing this post, I had just changed my automatic index fund contributions to reflect the new contribution levels. Based on the number of checks I have remaining in this year, that means I contribute an extra $462 to my Roth IRA for 2009.

I am closer to fully funding my Roth IRA, which performed better than my 401(k) this month, without removing money from savings accounts. Getting closer to achieving one of the financial goals I set for myself is rewarding.

Getting my 2009 tax refund now

With my 2008 Roth IRA fully funded with about 20% of the money coming from my federal and state tax refunds, I decided that I would rather have more of my money now to fund the Roth IRA than give it to the government. The tax refund I received this year was the result of three deductions for payroll tax purposes. I just submitted paperwork to increase the number of W4 withholding to four to keep more of my own money.

What are my plans for this money?
Since I used the tax refund to contribute to my Roth IRA, I will use the increase in net pay to add to my monthly contributions to my Roth IRA. I have been planning on increasing my monthly contributions each time I receive a merit increase. However, with the economy, I have decided rather than counting on a pay raise, I will just have to live with the income I have. With a change in withholding, I can give my Roth IRA a boost and if I receive a pay raise, then I can contribute even more toward my Roth IRA.

I estimate that I should add ~$700 to my Roth IRA contribution this year by changing my payroll withholding.

What are the drawbacks of doing this?
If tax laws change, I may owe more than I anticipated for 2009. My quick calculations based on my 2008 tax returns indicate that I should owe the federal government somewhere between $0-$200, depending on my itemized deductions and credits. Despite decreasing the amount of money withheld, it does not affect my state income tax much at all. Therefore, I anticipate that my state tax refund for 2009 should cover the cost of any federal taxes I owe with a small amount leftover.

If the tax brackets change or I earn more than I did in 2008 or any number of financial or life changes, I might regret changing my withholding. Frankly, I will have to see what happens when I figure my 2009 taxes next year.

My strategy is to get more money in my pocket now for a planned Roth IRA contribution rather than loaning it to the federal government interest-free. I earned it and I would like to put my money to work for me. Are you changing the amount withheld from your payroll check based on your tax refund?

Taxes done!

I just finished filing my 2008 taxes. As I did in the last year, I took advantage of free electronic filing of my 1040 form via TaxAct. My state has its own electronic filing site. My federal form took one hour to fill out and my state about 45 minutes. Total time invested: 2.5 hours. Much of that extra time was due to the changes in my state's electronic filing method, which included downloading third-party software and getting it to play nice on my iBook. All tax-relevant paperwork was filed in one location throughout 2008 and 2009 so it took me a few minutes to pull out the various envelopes and sheets to confirm I had all the papers I needed for filing.

I am my mother's daughter because I save all my tax paperwork in a single slot in my multicompartment file folder. Since I needed to refer to my 2007 tax forms to deal with my 2007 state tax refund, this file folder kept my earlier tax forms handy. Even with electronic filing of my taxes, I print out a paper copy of my forms and place the sheets in my file folder for easy reference and a backup to the electronic forms.

While tax refund was not as large as last year, my combined state and federal refund will be over $1,000. All of this money will go to fund my Roth IRA as a 2008 contribution. However, I am still over $100 short of the $5,000 maximum contribution limit so I will pull some money from my savings account fully fund my Roth IRA for 2008.

I received less money back from the government compared to 2007 for one large reason: the energy tax credit expired. In 2007, I put in a new energy-efficient picture window in my living room for which I could take a tax credit. Since that program lapsed at the end of 2007, the new windows I installed in 2008 had no effect on my income tax bill. However, the program has been reinstalled for 2009 so I am looking forward to the credit on when I file this year's taxes since I plan on replacing the remaining four single-pane windows on my home.

Looking at my 2008 tax form compared to 2007, I had less mortgage interest to deduct (more money going toward principle!), more interest income and a higher AGI (Adjusted Gross Income). I donated more cash to charity, but had no noncash donations. This year I may not give as much cash as 2008, but I will likely have more noncash donations to add to my itemized deductions in light of my desire to declutter. Since I did get a refund from the US government, I plan on adjusting my withholding so I get more money in my pocket now rather than giving the feds a tax-free loan.

I am one of those people who enjoys filing her taxes as soon as possible. I get it done, pay what I owe or get any refunds quickly and use my money to forward my financial goals. If you are getting a tax refund, how are you using it? If you owe the government, will it be easy to pay them the money?

Tax refunds and what I will do with them

Yesterday, I did my federal tax return using the web-based TaxAct, submitting my taxes for free, and today I filed my state return also for free. I was taken aback by the amount of the refunds I was owed by the federal and state government. When I increased my withholding last year after filing my 2006 tax returns, I figured that I would just about break even with the feds and receive a similar state refund. Well, I was wrong. Although my income increased from 2006, I had additional deductions I could take including an energy credit and I ended up with the same federal refund amount for 2006 and 2007. In addition, my state refund had increased compared to 2006! So what are my plans for the money?

2007 Federal tax refund
As I did last year, I calculated out how much I would have received each pay period if the money had stayed in my pocket. I divided my pending refund by 26 and then decided how I would have used the money if I could distribute it over my many spending categories. Here is the breakdown:
40% will be a 2007 contribution to my Roth IRA
20% will be additional principle paid on my 30-year mortgage
20% will be saved
20% will be spent

2007 state tax refund
My intention was to put this refund toward my Roth IRA. However, this was when the number was a bit lower. Here is the revised breakdown:
11% will be spent
89% will be a 2007 contribution to my Roth IRA

Between the federal and state refunds on top of my monthly deposits to my T. Rowe Price account, the total contribution to my 2007 Roth IRA are 69% of the maximum $4,000. With the cash value of the term life insurance (assuming it arrives soon enough), I will be able to max out my Roth IRA for 2007 and add a bit more to the 2008 monthly contributions.

I am in the third year of my 30-year mortgage so the payment will not make much of a dent in the principle. However, I do like to contribute a bit extra to my mortgage payment and a small decrease in principle will save some on taxes in the long run. Tying up my money in my home is not the best idea so boosting my savings is only to my benefit.

Spending some of the windfall is fine as long as other financial necessities have been taken care of. Since I have purchased a bicycle, I need a helmet. The extra money would encourage me to finally do it. I also have made much of the Pet Poo Converter to help cut down on my plastic bag usage. I will definitely be buying this item!

Both tax returns I requested be deposited electronically. This early in the tax season, I can expect to see my state refund in a few days and the federal refund in a week to ten days. I have not filled the latter electronically before so it may even be quicker than that. Regardless, I should have the refunds in hand for me to make my contributions, savings and buying decisions within the next month.