How To Have a Better Tax Year

What can a taxpayer do now to prepare for the tax year ahead? Maryland Smith’s Samuel Handwerger recently shared some advice.

Handwerger is a CPA and a full-time accounting lecturer at the University of Maryland’s Robert H. Smith School of Business. He also oversees TerpTax, Maryland Smith’s free tax preparation service, which puts volunteer undergrad students to work helping qualifying community members and UMD graduate students file their taxes.

He spoke this summer with ValuePenguin about smart money moves for taxpayers. Here is some of what he had to say:

Q: Which has more perceived value: a partial reimbursement after making a large payment or paying the correct amount upon time of service?

Handwerger: Another way of asking this question is: When do you see a CPA sweat bullets? Answer: When they have to tell a client they owe taxes as opposed to getting a refund.

In my career as a CPA, I have tried many times to explain to clients the concept that overpaying your taxes during the year through withholding taxes or estimated tax payments is not a good idea economically. After all – and we have all heard this – it is giving the government an interest-free loan. Yet roughly 80% of all tax returns filed in the United States are requests for refunds. Even if you argue that the overpayments are due to errors in withholding directions given by employees to their employers, with a couple of extra seconds of effort this could be rectified. Clearly, Americans would rather see a refund rather than having to write a check.

Behavioral economic practitioners will explain this phenomenon as a clear illustration of prospect theory. Humans, by and large, are loss averse when compared to “winning” by a factor of about 2 to 3. To have to owe taxes, even if fairly insignificant, feels multiple times more hurtful when compared to even a small refund.

Refunds are perceived as “winning” at the tax game. To the average taxpayer the refund says: “See, I won the tax game. I don’t owe as much as the government thinks!” CPAs also get caught up with this “winning”-oriented attitude when they proudly tell the client that they are due a refund, as if the CPA’s prowess at preparing returns is the only reason.

However, prospect theory has shown that it is not difficult to educate people to undo the normal tendency to shun losses, i.e., not getting a refund, so vociferously. If that is true, why have I had such a hard time doing similarly with my clients with regards to owing taxes?

Here I believe we have the added hurdle of overcoming not just the “winning” or “losing” money perception, but also the perceived foe – in this case, the government. Seems like no one is impervious when it comes to paying the government. Withholding taxes don’t feel like paying the government, as it is money not even seen. It’s deducted before it goes to your pocket, so it doesn't even seem like it belonged to you to begin with. Paying at tax time from the money that you did put in your pocket, that’s a different story.

Withholding taxes first started as a temporary measure during World War II in order to help the government pay for the costly effort. It came with a highly patriotic pitch to it and was easily endorsed by Americans. Check out Gene Autry’s song “I Paid My Income Tax Today.” The government recognized that what was good for the goose was also good for the gander and withholding taxes easily became permanent. Prospect theory was understood, at least intuitively, even then.

Q: At what point does itemizing tax deductions become more worthwhile than taking the standard deduction? What tips do you have to make itemizing deductions less intimidating?

Handwerger: This is simple mathematics. If your itemized deductions are greater than your standard deduction, you itemize since your taxable income will be lower and, hence, lower taxes.

For example, in 2021 the standard deduction for joint tax return filers will be $25,100. How many people will have itemized deductions higher than that amount? Well, not too many. In 2018 only a little more than 10% of all tax returns filed were taking the itemized deduction. This was down from 30% in 2017 reflecting the outgrowth of the Tax Cut and Jobs Act, which significantly raised the standard deduction.

So, you could simply bet with the odds and take the standard deduction without thinking about it, or you could do a little math exercise, particularly wise to do if you own a home with a mortgage.

Here’s what to do. Take your mortgage interest paid for the year, add your charitable contributions, and then add on $10,000, the highest amount allowed for the state income and real estate tax deduction. If that amount is getting you close to the standard deduction, then it pays to go through the motions of completing Schedule A to see if indeed your itemized deductions will dwarf the standard deduction and help you lower your taxes.

As far as fighting the intimidation of going through the motions of itemizing, you can mentally calculate that for every dollar above the standard deduction your itemized deductions take you, you will save around 20 cents for each of those dollars, as based on the national average effective rate in 2019.

Q: Therapy and travel costs associated with medical care are examples of purchases that are eligible for tax deductions. What advice would you give for consumers to better track tax-deductible purchases throughout the year?

Handwerger: Medical expenses are another category of itemized deductions, but they are not for everybody. No, I am not tax profiling, I am simply alerting you to the fact that the medical expense deduction is limited to only the amount of your out-of-pocket medical costs that exceed 7.5% of your adjusted gross income. To see the benefit of this deduction, you will need to have either some relatively high medical expenses (not covered by insurance) or lower income to overcome the limitation hurdle.

To keep track of these is not an easy task as you will have to resort to some degree of recordkeeping. I use one credit card specifically for costs that I think are deductible so that at the end of the year I can classify these by category. For example, I use this card only for charitable contributions, medical costs, and fancy luxury items that I know are not deductible but where the dollars squandered feel better when charged to the credit card reserved for tax deductions. You can also download a medical deduction spreadsheet for free from squawkfox.com.

To keep track of the medical travel miles and costs, you can try TripLog, which is reasonably priced, and is great for self-employed individuals. Just keep in mind that the deduction per mile for medical travel is 16 cents per mile. It is much better for deduction entrepreneurs at 57.5 cents per.

Q: What major life event(s) should warrant Americans using a tax professional as opposed to a DIY tax preparation service?

Handwerger: There are at least two major life events where the letters “C, P, A” become very valuable for the purpose of tax preparation – your first home purchase and your first child, whichever comes first. However, don’t expect the CPA’s tax software to outdo whatever your DIY online favorite can do.

Nope, the CPA’s value here at these milestones is long-term tax and financial planning advisory. You will want to hear what the CPA has to say about retirement planning, insurance, and estate strategies, amongst others. The CPA is your best quarterback for these very important areas of your financial life.

Of course, opening your own business or entering a stock option plan at work are also immediate invitations to seek a CPA. Both are highly tax complex transactions and should be only started with the advice of a CPA.

Q: What is the one piece of advice that Americans should take regarding yearly financial and tax planning when it comes to health care?

Handwerger: Wow, a loaded question. Trying to pin it down to just one piece of advice seemed daunting at first. But after a little reflection, it was easy. My advice: “Buy” the risk.

That means buy insurance to have someone else bear the burden of the cost of the “what-if.” Buy health insurance, both regular and long-term care, for what-if you get ill or need long-term rehabilitation.

Buy disability insurance. Your odds of something interfering with your income-producing years are greater than a premature permanent trip to heaven.

Buy catastrophic coverage. I have seen too many families torn apart financially when disaster strikes, and the financial burden falls on extended family members. Many of these policies can be had through employment, often in tax favorable ways, so check with your HR department at work.