Does Anyone Understand What’s On a Tax Return?
June 15, 2022
Welcome to The Retirement Tax Podcast, where hosts Steven Jarvis, CPA, and Benjamin Brandt, CFP, work together to bridge the gap between tax professionals, financial advisors, and their mutual clients to help reduce most people’s largest expense in retirement: taxes. Each week, they will dive into conversations around taxes, focusing on what you can truly control (instead of what you cannot) and how to set yourself up financially for your future.
So you’ve gotten your tax return and gone through the stress and struggle of processing the paperwork, but now you have a bunch of numbers—and you may or may not know what they mean. This episode is all about understanding what’s on your tax return and how to use that information to create an effective plan for the next year and beyond.
Listen in as Ben and Steven take a look at some of the most common questions they get about tax returns and share some helpful insight into each one. You will hear about the most important things to take note of on your tax return, the important lessons that can be learned from this new data, and more.
What You’ll Learn In Today’s Episode:
Read The Transcript Below:
Benjamin Brandt: Welcome back to the Retirement Tax Podcast. I’m your humble co-host as always, Benjamin Brandt, and joining me today is the delightfully handsome, Steven Jarvis. Welcome to the show.
Steven Jarvis: Thanks for being here with me as usual, Ben. Delightfully handsome, I like that. That’ll go up on my wall to remind myself how great I am.
Benjamin Brandt: I couldn’t decide between delightful and handsome so I combined them.
Steven Jarvis: Yeah. Why not?
Benjamin Brandt: Yeah. This is an audio podcast, so people can assume we look like whatever they assume we look like.
Steven Jarvis: That’s right. On the list of compliments I get that just don’t feel like compliments that you have a face for podcasting. You have great social skills for a CPA. It’s like you just leave the last part off. I think I have okay social skills.
Benjamin Brandt: Exactly. Yeah. My social skills have been described as adequate and so I run with that. What are we talking about today, Steven? We’re talking about, we’ve got our tax return back. We’ve gone through whatever stress and struggle it is of calculating what our income tax is going to be, processing the paperwork, sending it off to the IRS. I assume they’ve already cashed the check.
Now we’ve got a whole bunch of numbers on our tax return that may or may not mean something. That’s what we’re going to talk about today, is, what is important on my income tax return and what financial planning or income tax lessons can we learn from this new data that we have received?
What are some common questions, Steven, that you get from clients when it comes to their tax returns and the numbers involved?
Steven Jarvis: Yeah. That’s really where this topic came from, was some of the questions I was getting, and I would love to hear your insight from the financial planning standpoint as well, as far as where people get hung up or where they have questions, what comes back up every single year. Because it would be nice to think that taxes could be something we would learn once, then we would just know, but taxes is not like riding a bicycle.
It does not just come back to you each year. There are understandably questions that people have. We’re a couple of months removed from the tax deadline now, but we pay taxes all year so I like to keep it top of mind. I had just taken some notes of some of the most common questions I was getting this last tax season as I was reviewing tax returns with clients.
One of the more common ones was, what is my effective tax rate or what is my average tax rate? What am I actually paying? Which is a great question to ask, because we’ve talked about tax brackets before and marginal rates or if you look up how much am I going to pay in taxes? You’ll get these nice round percentages. But since we have this progressive tax system, that percentage is almost never what you actually paid in taxes.
Your effective tax rate at the end of the day is going to be however much of your money the IRS kept, your total tax. That’s not how much you paid on April 15th. That’s how much they kept throughout the year, divided by your taxable income. Now, there are people who will take total income or adjusted gross income. What’s really important is that you’re consistent.
This is a helpful number to focus on so that we can see the impact our decisions, or our changes in income have from year to year. One of the conversations that prompted this particular topic, I was working with a taxpayer who got really focused on the fact that their refund had gone down from the prior year, because we know that taxes are emotional for all of us.
The refund had only gone down several hundred dollars, maybe a thousand dollars and the taxpayer had significant income, but they didn’t understand. They were in the same marginal tax bracket both years so they didn’t understand, well, why am I paying a different amount in taxes?
Especially as we earn more money, each dollar of income is going to shift that effective tax rate up because when we earn more money, we’re paying whatever the highest bracket we’re in is. That effective tax rate is going to keep creeping up.
Benjamin Brandt: Yeah. That’s interesting. The effective tax rate. When you think about the 22% bracket or the 24% bracket, two people in the 24% bracket could pay wildly different amounts in income taxes. One, because of credits and things like that. Two, because there’s hundreds of thousands of dollars inside that bracket. You could be $3 into the 24% bracket or $3 away from the top of the 24% bracket.
Your income would be potentially hundreds of thousands of dollars difference. Yeah. Looking at that marginal bracket only gives you part of the story. I also think effective tax rate is important because it’s going to be a smaller number generally than your marginal rate. That gives you context historically, like especially when you think about, well, something like a Roth conversion.
Your effective tax rate, sure, you’re in the 22% bracket, but your effective tax rate is 12 and a half percent. We can think about 12 and a half percent and say, “In the grand scheme of the last 30 years or the next 30 years, does 12 and a half percent seem like a good deal compared to where I think taxes might go in the future?” You can say, “Well, I don’t know, 12 cents out of a hundred, that does seem like a good deal.”
You can use that context that you can really only find through the effective tax rate to say, “Am I making good choices? Does this seem like a good deal from where taxes may go?” We have reasonable expectation that taxes are going to go up because of tax cuts that are going to sunset. Honestly, we don’t know if that’s at what level or if that’s even going to happen. Maybe they’ll get renewed, maybe not.
Timing the tax market I suppose this is just as prudent as timing the stock market. Probably shouldn’t be done. Yeah, that’s why that’s why effective tax rates, to me, I’d rather talk with clients about effective tax rates than marginal rates, just because I feel like that’s a more meaningful number. How much did I pay in total real dollars versus how much did I make?
Steven Jarvis: The other thing that can be really helpful with focusing on effective tax rates compared to marginal tax rates is when we’re looking at how much we should have withheld from our income, because this is how some taxpayers end up with huge refunds where they could have kept some flexibility over their own money if they held onto it a little bit better.
Because if you try to decide your withholdings based on your marginal rate, and you’ve just bumped into the 24% bracket and great, I’m going to have everything withheld at 24%, well, hold on a second, you’re effective rate at the end of the year might be 15/16/17%. Now we’ve just left the IRS with a bunch of our money all year.
Benjamin Brandt: Right. That’s tricky because if you do a Roth conversion at the end of the year, and you think I’m in the marginal rate, 22%, withhold 22%, withholding the effective tax rate only really works if we have all of our other income sources dialed into that same effective tax rate. We know that social security and some of these other big operators aren’t super flexible as to what they let us choose.
It can get a little lumpy at the end of the year, choosing what those are. If we have everything dialed in perfectly, then effective is the way to go. If we don’t, we’ve got to have some sort of hybrid between effective and marginal, which is exactly as confusing as it sounds.
Steven Jarvis: Yeah. That’s a really great point, Ben. Yeah, you’re right. None of this stuff is simple. If we’re at the beginning of the year, looking ahead and saying, “Hey, how much should I have withheld from social security, or if I’m going to make monthly distributions, or I still have earned income, I’ve still got wages?” Then the effective tax raises is probably going to give you a better idea of how much I need withhold throughout the year.
But you’re right, if we’ve gotten to November or December, we’ve already earned most of our income and paid most of our taxes. Now we’re just going to do our Roth conversion or take an extra-large distribution end of the year, now it gets reversed and we say, “Great. We know what happened most of the year. Now that last distribution probably mostly will be at our marginal rate.” That probably is a better one to use.
Benjamin Brandt: Yep. I think the longer you’ve been doing this, whether you’re a do-it-yourself tax planner, or you’re working with an accountant, or you’re working with an advisor or some combination of all three, the more years you are retired and you have a similar repeatable income, the closer you’re able to dial this in.
The more tax returns Steven has of my clients, the closer we’re able to dial that in to getting that proper withholding on our tax rate. Repetition is going to get you closer unless you’re already a tax savant.
Steven Jarvis: Yeah. Yeah. I don’t know that I would claim tax savant. Maybe that’s what you’ll introduce me as the next time we talk. One of the other things that came up several times this last tax season, again, taxpayers asking great questions trying to understand their return. There’s a line on the 1040 after we’ve calculated some of our income tax that just says other taxes.
There’s one in particular that seems to come up a lot for people who are looking closely at this, because it feels like they’re getting double hit here with the net investment income tax, because the form that calculates that, which it’s an additional 3.8% that we pay on certain types of income over a certain threshold, we won’t get too lost in all the numbers in our audio podcast here.
But at some point you’re going to have to start paying this 3.8%. One of the specific ones that came up with the client, they could see where their capital gains were included in their regular income. They paid their marginal rate and then they had this extra form and they’re like, “Wait a second. That’s the same income from before? Am I just getting taxed twice here?”
Essentially yes. Yes. It does feel that way because since we are cutting into two pieces and saying, “Here’s your marginal rate.” Whether it’s short-term gains and is at your ordinary income tax rate or it’s long-term gains and it’s at capital gains rates, we have the first piece. Then if we’re over that certain threshold, yep, let’s go ahead and add another 3.8% on there and then just lump it in this very generic bucket that says other taxes.
Benjamin Brandt: Yeah. Double jeopardy applies for criminal law, not tax law.
Steven Jarvis: Yep. Yeah. Well, because those same dollars are then going to get taxed at the state level. Your same dollars get taxed all sorts of different times.
Benjamin Brandt: Right. Right. I mean, full disclosure, I mean, this tax only applies to you if you have a very high income and then also have high income… Excuse me, high investment returns on top of your income. I mean, you’ve done well thus you must be punished, but we don’t want to be too political on the podcast. That’s net investment income tax, net. If you’re a savant in net investment income tax, are you a nitwit?
Steven Jarvis: Probably. Yeah. There’s something to strive for. Let’s all be nitwits.
Benjamin Brandt: Let’s all be nitwits.
Steven Jarvis: Or maybe not. This-
Benjamin Brandt: Yeah. That’s a dad joke.
Steven Jarvis: Yeah. Well, hey, we’re both dad here, dad jokes are the best. My kids would strongly disagree. They think they’re the worst.
Benjamin Brandt: They do think they’re the worst, which makes me like a more-
Steven Jarvis: Yeah. I’m right there with you, Ben. So we’re talking about right here, where there are instances where you get double taxed and I’m sure for a lot of people listening they’re like, “Ah, this sounds so confusing. How do I keep this all straight?”
I’m right there with you, because then we have things on the flip side where we don’t want the fact that there are some cases where you are going to see the same number twice lead you into this belief that that’s going to be the case all the time, because there are some instances where I think we’ve talked about this before that we can’t just inherently trust software all the time.
Because there are instances where the tax forms you get will lead you down this road of inadvertently having the same dollars taxed twice. You can follow all the right steps and end up in this really painful situation. Worked with a client on that exact situation this year, where they had been do-it-yourselfers when it came to taxes and so they came.
We worked together at the recommendation of their advisor to say, “Hey, let’s take another look at these taxes.” This was specific to some stock option exercises, but it’s not the only place it comes up where they got their forms in the mail. They typed it all into the system and they ended up paying tens of thousands of dollars in extra taxes because the tax forms don’t really set us up for success.
I bring that up in connection with what we’re just talking about with the net investment income tax, because there’s very few things we can just take for granted when it comes to taxes. They aren’t consistent, the same logic doesn’t apply in every place.
Especially for our DIYers out there, if you’re into some of these more complex areas or if in a particular year you get to a situation you haven’t come across before, I would just really caution you with the thought process of, oh, well, I pay for a software so I must be covered. That doesn’t always get us to the same level of certainty.
Even if you don’t want to hand over your taxes completely every year, you can definitely find someone who will take that second look for you every couple of years or just do a double-check for you.
Benjamin Brandt: Absolutely. Absolutely. We’re also looking at what amount the IRS actually keeps.
Steven Jarvis: Yeah. When we talk about what’s important on my tax return and I know we’ve talked about this on the podcast before, but I’m just a huge proponent of making sure we focus on how much of your hard-earned money the IRS has kept, as opposed to just whether I made a payment or got a refund at tax time, because this gives us such better context for what’s actually going on.
This helps us with what’s our effective tax rate? But to me, that’s a better indicator of what’s happening from year to year, as opposed to how much of a refund we got.
Benjamin Brandt: Fantastic. When we look at our income tax, we can review our sources of income. What all sources of income do we have? Do we expect those to change?
Then like we mentioned in a previous bullet point, now that we’re thinking about those pieces of income, do we have all of our withholdings tied to those income dialed in properly so that if we have big changes to our income, like Roth conversions, we could just be more accurate with withholding or estimated payments or things like that?
We should maybe itemize or just take stock in what different sources of income do we have and how might we expect those to change?
Steven Jarvis: Yeah. When we look at that first page of the 1040, where we can see the different sources of income, not all of those get treated the same as far as what taxes applied or how they apply to different thresholds. We don’t want to just say, “Does my total income feel right or does it match what I expected?” But, is it in the right lines? Sometimes that can be really non-intuitive.
Worked with a taxpayer this year who as they retired and separated from service, they had received some large one-time payments that in their minds was that was part of their retirement so it should be on IRA distributions or pensions and annuities.
It should be on one of those retirement lines, but it got reported to him as W-2 wages, even though it was the separation payment and so it went online one of the 1040. We had to work through, okay, is this in the right place? Does that make sense? Yeah, it’s not always really intuitive.
Benjamin Brandt: Then next idea what we can learn from our tax return. We can review our definition of the perfect income tax refund, which is a bit subjective but I think many people would say the perfect tax return is getting a dollar back or maybe it’s paying a dollar in kind of depending on how you look at it, but we can review refund versus payment and then how we decide how we define winning or not that tax year.
Steven Jarvis: Yeah, definitely. I would, again, strongly encourage that we don’t look at a big refund as winning for all sorts of reasons. We’ve covered that on another episode as well. Right.
Benjamin Brandt: Wasn’t that interesting though? I think that it is another example of things that change when you’re retired. I think during the accumulation years, when a lot of our income it’s in our paycheck and it’s withheld. You file your taxes on April 15th and you get $2,500 back, that feels like a big win.
I think even if that’s true, even if that is defined as a win for you, when you’re retired and you’re taking money out of your savings, that $2,500 isn’t just an amount that I get back at the end of the year. That $2,500, that could have stayed in your IRA. You wouldn’t have paid taxes on it and it could have compounded for an additional year.
Wash, rinse, repeat that for 30 years, you could actually be losing money by getting a big refund like that. Add that to the long list of things that changes when we switch from the accumulation years of our life to the distribution years of our life.
Steven Jarvis: Yeah, most definitely. Now, even though a lot of these topics today have come from questions that came up this year, we want to make sure we’re getting to specific questions that our listeners are asking because we love it when you reach out and ask questions. The question for today is we are thinking about moving out of state in retirement. What should we take into consideration as far as taxes go?
Benjamin Brandt: Excellent question, Steven. I think that this is going to sound a lot like so if we have some super fan listeners that have been listening to us since episode number one, which is all the way back in like October of last year, September/October, something like that, is it’s going to sound a lot like our same advice on charitable contributions.
Our advice on charitable contributions is you should give to charity because you want to give to charity, not because you want the tax deduction, because at the end of the day, you’re still losing the thousand dollars you give to charity, right? I think the same logic applies when we’re moving. We move because we want to move. I don’t want you to move because you’re going to save a percent here, a percent there on state income taxes.
You could maybe convince me it would be a good idea to move to avoid estate taxes. But then we’re generally talking about millions and millions of dollars in net worth, but I want you to move because you’re moving for something really specific, I’ve got a hobby or a job change or a family situation. Or I’m tired of shoveling my driveway, which is what a lot of our North Dakota, South Dakota, Minnesota, Montana clients say. You’re moving for a really specific reason.
Now when we’re sure that we’re moving for a specific reason and we’ve got it narrowed down to three states, Tennessee, Georgia, and Florida, well, then we can start to look at some of the nuances between those states and say, “Okay. State A isn’t going to tax my social security, state B isn’t going to tax my pension payments and state C doesn’t have any property taxes.” Or something like that.
My point would be decide you’re going to move first because you want to move. Nothing to do with taxes. Then we can start to use taxes as differentiators between, gosh, the place that I like is on the border of two states, picking one state or the other. Something like that. Picking between Fargo and Moorhead or East Grand Forks and regular Grand Forks, things like that.
The other thing that I would really caution you to do, and we have some flexibility, even if we are thinking about moving, I would really encourage you, this is way more on the financial planning side than the tax side, but I always encourage people to rent for six months when they move to a new place before they really make that significant financial commitment of putting down a down payment on 20% on a residential property, something like that.
Rent for six months and hire a local realtor. Renting, you might want to be on the touristy part of town, you might not. Every town has a right and a wrong side of the tracks. Maybe you’re on the wrong side of the freeway where you’d rather be on the right side of the freeway, whatever that might be. Rent for six months, start to think like a local and then make those… Buying a house might be a 10 or 20-year commitment.
That’s my financial planning side, is I always recommend people rent for six months. I know we hate to rent. I know we want to be participating in equity from day one, but I’ve also helped clients sell houses a year or a year and a half after they bought. It’s almost always a lose money proposition. I’d encourage you to Airbnb it for a couple of months, six months and then make that choice.
Steven Jarvis: Yeah. Lots of great insight in there, Ben. You covered the three big things that I always talk to people about when they’re thinking about what state should I live in? Family, friends and hobbies or activities. We’ve got to be focused on where we’re going to be happy. Then, yeah, there could be tax considerations that come in, but like we talk about, taxes are a passenger on the bus, not the driver.
If we know years in advance that it’s always been our dream, that here’s where we’re going to retire and we’re going to move to this state or we know we’re going to retire to this state because that’s where all of our grandkids are, there is other tax planning we can do, which comes back to just relative tax rates in different years.
If we know we’re going to retire in a higher tax state, because that’s where our family is, maybe then we go ahead and more aggressively accelerate income. Or if we know we’re going to retire in a state that doesn’t tax IRA distributions, maybe that comes into our consideration of whether we do Roth conversions.
There are some things that we can do there. If we know farther in advance, we’re going to be moving. Again, we started with, this is where I want to live. Now what do the taxes look like?
Benjamin Brandt: Right. Absolutely. Excellent. Well, that’s all we’ve got prepared for this week. Until next time, Steven, don’t let the taxman hit you where the good Lord split you.