Tax Guide for Contractors - or - 1099MISC WTF?

What's a contractor?  For the purpose of this guide, I'm considering a contractor as anyone who's paid for work on a 1099MISC vice on a W2, or who works for themselves and is paid cash by their customers.  I say work, because I'm not talking about an Engineer getting paid a few bucks for coaching softball.  I'm talking about someone who is in the business of doing the work they get paid for.  This guide is best used by someone who earns the majority of their income from the work they do that's paid in cash or via a 1099MISC.  If you're a painter who gets most of his money on a W2, and gets a minor portion of their income on a 1099MISC, this guide can be helpful, but it's really not the prime focus of the guide.  This guide is also intentionally generic, so it can apply to a variety of businesses.

What does this guide not do? 

Foremost, it assumes you are either a Sole Proprietor, or a Single Member LLC.  In other words, the business is reported on your personal tax return, vice the business filing its own tax return.  There are advantages and disadvantages to forming other business entities, but those are best discussed face to face with a professional you trust. 

Second, it is mostly for contractors who provide services, vice those who make or buy items to sell.  There is some good information for them too, but I won't be covering inventory or cost of goods sold.

Third, it's not a guide on how to do your taxes.  It's a bunch of best practices I've found to make running your business easier, your taxes simpler, and your life better.  It's not the only way to do things, but it's what I've found works best.  I assume you either have a tax professional who does the tax return, or you're pretty smart and capable of using tax software yourself (though I recommend having a professional check it the first couple years.) 

Fourth, it's for SMALL businesses.  If you're approaching 7 figures of gross income, get a professional CPA involved.

How does a 1099MISC / cash business work for taxes?  You’ll be filing a Schedule C and reporting ALL income, and then taking any legitimate deductions to come up with ‘net’ income.  This is what you pay taxes on.  You have to pay it all as you go, or at the end of the year when you file your tax return.  Also, there's nobody to pay for Social Security taxes except, well, you.  Most people are barely cognizant of the 7.65% that's taken right off the top for Medicare and Social Security taxes out of their paycheck.  What even the most aware don't realize is that their employer matches this deduction!  As a 1099 recipient (self employed is the IRS term) you have to pay both the employee and employer portion!  This means a 15.3% additional tax!  Imagine you're in the 15% tax bracket - that means you actually pay 30.3% taxes!  And this doesn't even cover state taxes!

The good news is that, unlike a W2 employee, you only pay these taxes on your 'net' income.  This means you get to take all ordinary and necessary expenses off the top, before you pay a dime in taxes.  Even employees with business expenses still pay their half of Social Security and Medicare taxes before any deductions.  So what is 'ordinary and necessary'?  I like to boil it down into two categories: 1 - things you pretty much have to pay - like licensing, commissions and fees. 2 - things you pay because you expect them to increase your income.  If they meet either of these requirements, they're pretty much a lock as being deductible. 

Knowing the above, it's important to give one of my biggest pieces of advice - you pretty much should NEVER do something just because you expect it to help on your taxes.  Spend money only if you have to, or because it's the best idea for your business!  This has two benefits: 1 - you don't waste money on stupid s**t.  2 - chances are the deduction is legitimate.

So what can I deduct?  Here’s a non-exhaustive list: Supplies, rent, vehicle mileage, travel, bank fees, taxes, licensing, insurance, home office, office supplies, equipment, marketing, advertising, subcontractors, employees, postage, education, legal and professional expense, bank interest and much, much more.  I’m going to give details on a few here:

Marketing Expenses:  Business cards, website fees, posters, signs, sponsorships, commercials, advertising, pretty much anything you do to get someone to call YOU when they need your type of services.

Training, Education and Licensing:  Whatever you pay to maintain your ability to do your business is deductible, as well as things you do to increase your skills, as well as what you are allowed to do in the field.  Classes, seminars, books and certificates mostly all qualify.  Commercial Drivers License is another example.

Insurance:  I'm not talking about homeowners insurance here.  I'm talking about ‘oops I screwed up and someone is suing me insurance.’  Sometimes this is called Errors and Omissions Insurance, sometimes it’s a liability bond, or a rider on your homeowner’s insurance.  Also, if you pay a rider to your car insurance for business use, the difference between that and regular insurance is deductible.  There is also a self employed health insurance deduction that allows you to deduct your health insurance costs if you have no other insurance source (if you can get insurance through your spouse’s work this is a no-go.)

Entertainment Expenses:  Eventually you'll be with a client, or potential client, and pick up the tab for lunch, or dinner, or a stripper (don't do that - it's tacky - and questionable as a deduction).  Generally, if you expect the expense to result in a sale that makes you money, either immediately, or in the future (whether it ultimately does or not doesn't matter, as long as you expect it to) it's deductible.  I recommend writing the name of the client on the receipt, as well as a quick description - "referral source", "potential client" or something like that.

Travel Expenses:  These are a toughie.  People love conflating personal and business travel.  If you travel to Maine to visit family and see the lobster festival, and go to dinner with a client that is moving to your area, the trip is primarily personal.  You can deduct expenses DIRECTLY RELATED to the meeting with the client, but little else.  I recommend keeping business and personal separate.  You can visit a friend for dinner on a three day business trip, but don't do business for an hour on a three day personal trip.  Also avoid what I call BS travel.  Flying to Vegas to assess potential markets is transparent vacationing disguised as business travel, especially if you spend 23 out of every 24 hours in the casino!  Be reasonable!  Go on trips that are going to increase your money-making potential.  Stay away from any others.  For legitimate travel, you get airfare, rental car, tips, taxis, laundry, internet and phone, as well as 50% of meals and any other reasonable and necessary expenses.  Travel assumes overnight trips away from your home area.

Cell phones, laptops and tablets:  Do yourself a favor, get a business only laptop, cell phone, tablet and/or computer.  It is simply too difficult to calculate expenses on a part personal and part business electronic device.  Don't share your business number with friends and family (other than wife and kids).  If you keep everything separate, the deductions are easy and legitimate.  If you don't, you have to establish a business use percentage, and worry about listed property rules - which suck!

Vehicle Expenses:  Keep a mileage log.  Let me say it again, unless you have a vehicle that is 100%, no s**t, total business and no personal use, keep a mileage log.  Don't worry about gas, repairs, oil changes, insurance or any other car expenses (except as discussed above under insurance).  There are other ways to track vehicle expenses, but mileage is the best.  Do track annual car taxes and finance charges.  The easiest mileage log is a notebook where you right the date, the trip purpose and the miles driven.  You will also need to know the total miles the vehicle is driven for the year, so write the odometer reading down every January 1st!  Mileage will be one of your biggest expenses, so keep track of it religiously!  10,000 miles of properly tracked vehicle mileage can result in $1500 of tax savings!

Home Office:  Set aside a space in your home that is 100% business use.  Never used for anything else, and regularly used for business.  This is where you keep your business records, your business computer or laptop, make your sales calls from and meet clients.  The tax term is regular and exclusive business use.  If you do this, you deduct a percentage of the household expenses - rent, interest, taxes, utilities, insurance, repairs, etc, based on the square footage of the office ratioed to the home square footage.  Expenses directly related to the office, such as a dedicated phone line; do not have to be ratioed.  You can also take a small depreciation deduction for the home losing value (let your tax guy handle this - it's a b**ch!) 

Depreciation:  Some items that you buy for your business, that have a useful life longer than a year will have to be depreciated over time rather than deducted all at once (examples include computers, digital cameras, machinery, big tools or office furniture).  There are many options for deducting it up front, but be wary of this, there are tripwires that can cost you if you dispose of something before it has passed its useful life.  Talk about these items with your tax advisor.

Employees or Subcontractors:  If you pay someone to do work for you in your business that is deductible.  Usually you will hire them as a subcontractor, and may even pay them in cash (use a check!)  If you pay them more than $600 in a year, you will need to issue them a 1099MISC – see your tax guy about this as soon as you pay a subcontractor.  If you want to hire regular employees, you will have to withhold taxes from their check.  Get help with this!  Make sure you talk with your tax guy about the difference between an employee and a contractor.  If you call an employee a contractor, you could be in trouble.  But if you just have a few guys that you call when you have excess work and they can decline to do the work, and you only pay them if they do, they are probably a contractor.

What about Record Keeping?  This is where the rubber meets the road.  Good record keeping will save you when it comes to tax time.  Your records don't need to be extensive, but they do need to be accurate and useable.  I hate double entry bookkeeping and would never recommend it as a tool for a basic contractor.  I also have found that the various bookkeeping software programs are virtually useless when it comes to taxes.  They may help when it comes to managing the business, but they suck for doing taxes.  The best and easiest record keeping method I've found involves a small notebook, a big notebook and an envelope or box.  The small notebook is for mileage, discussed above.  The big notebook is for every other expense.  You need simple columns set up: date, description, cost and payment received (if you pay something, it goes in the cost column, if you’re paid it goes in the payment received column.).  You can add categories, but don't really need to, if you're unsure something's deductible, write it down and let your tax guy tell you if it's deductible.  The box/envelope is for receipts - just throw them in.  Really?  No sorting, categorizing or organizing?  No.  Simply put, your odds of ever needing them for an audit are slim to none.  Save the box, notebooks and tax returns for 7 years, and then throw it all away.  If you ever do get audited, there's plenty of time to sort through the box and organize it to match the notebooks - but why do it if it's not necessary.  If I'm doing your taxes I'm going to use the notebooks, and remind you that you should have a receipt for everything.  You don't have to prove things to me.

Do I need a Separate Bank Account?  This one might be a little controversial, but I believe it's the be all end all of successful businesses.  Combined with record keeping discussions above, and budgeting discussions below, this will make everything easier.  Open a separate bank account for your business.  It doesn't have to be in a different name, just separate from your personal business.  If you use credit, get a second credit card that is exclusively for business (again, it doesn't have to actually be a business credit card, just one that you use only for business).  Put all contractor business income in this account, and pay all business expenses out of it, or with the business credit card.  Pay off the business credit card out of this account.  The only expenses not paid out of the account are car expenses (especially gas) and home office expenses that will be divided based on square footage as discussed under home office above (utilities would not be paid out of the account, but office supplies and business only cell phone would).  The beauty of this method is that it simplifies budgeting as we'll discuss below, and it allows reconciling of expenses to make sure your notebook covers everything.  A good tax expert should be able to compare your account statements with your notebooks and know if you missed something (assuming you don't intermingle personal and business expenses).

How do I Budget if my Income goes up and down?  Now that you have an account that is separate for business, you can start thinking about budgeting.  Your income may fluctuate wildly, so you can use the business account to pay a "salary" to your personal account.  I recommend letting some money build up in the business account until you have a feel for your income level.  It will probably start small, but build up over time.  Once you have a good feel, you can pay yourself this salary.  The salary should be no more than 50% of your gross income or 60% of your net income.  You need to play around with it.  Start small and raise it if income exceeds expectations, but NEVER pay yourself more than 60% of net income.  Having a salary allows you to budget like you had a normal job.  Keeping a buffer amount in the account allows you to have a "salary" even during lean months.  By paying yourself a salary and saving the rest, if you have a really big month, you end up saving more, which in turn allows you to have the money to pay the tax bill that the big month will generate.  When you file your taxes, you should have plenty of money to pay the tax bill, and still have money left to maintain a buffer, and, if you're lucky, have the ability to pay yourself a bonus to your personal account for a big purchase or vacation!

Do I need to make Estimated Payments?  My advice is that you should use the budgeting advice above to pay your taxes.  You'll still need to make estimated tax payments if you're making good money, but you should pay the minimum required to avoid an underpayment penalty.  Your tax advisor will calculate them for you, but to explain simply: you need to pay at least as much as your prior year's total tax liability in withholding or estimated taxes to avoid a penalty (oversimplified explanation, but really all you need to know).  This is an easy calculation for your tax guy and he will set up quarterly payments and provide vouchers for paying them.  (The timing is a little weird.  You pay 4/15, 6/15, 9/15 and 1/15.)  You can also pay varying payments to try to avoid a tax bill, but it gets complicated, and the government won't pay you interest.

That’s it!  Hopefully this makes your life as a contractor easier.  As always, I’m available to answer any questions you have at taxadvisor@email.com.  If this saves you a bunch of money, consider a tip using the button above.  Also feel free to make this better by emailing me your ideas and best practices!

Real Estate Agent Tax Guide

So you've got your real estate agents license and that first commission is finally on the way.  No way around it now, you have taxable income.  The question is, how much?  And, how do I pay as little as possible?  This post assumes that you will be paid on a 1099MISC, as a self employed Real Estate Agent.  If you're getting a W2, some of this will be useful, but not all.  I'm also assuming that you work for a real estate company, and aren't completely independent.  Much of this advice isn't gospel, it's just what I've seen and think works best.  In some ways, it's a list of "best practices."  As always, you should use this post as a starting point, and seek professional assistance when it comes to your personal situation.  I am also going to assume you have not formed a complex business entity such as an S Corporation or Multi Member Limited Liability Corporation.  There are benefits and disadvantages to these, but you need to talk to a professional to understand them.

I'm going to start with some basics, and then get into details.  The first big surprise you will have is that nobody's taking taxes out of your paycheck.  You have to pay it all as you go, or at the end of the year when you file your tax return.  The second thing is that there's nobody to pay for Social Security taxes except, well, you.  Most people are barely cognizant of the 7.65% that's taken right off the top for Medicare and Social Security taxes out of their paycheck.  What even the most aware don't realize is that their employer matches this deduction!  As a 1099 recipient (self employed is the IRS term) you have to pay both the employee and employer portion!  This means a 15.3% additional tax!  Imagine you're in the 15% tax bracket - that means you actually pay 30.3% taxes!  And this doesn't even cover state taxes!

The good news is that, unlike a W2 employee, you only pay these taxes on your 'net' income.  This means you get to take all ordinary and necessary expenses off the top, before you pay a dime in taxes.  Even employees with business expenses still pay their half of Social Security and Medicare taxes before any deductions.  So what is 'ordinary and necessary'?  I like to boil it down into two categories: 1 - things you pretty much have to pay - like licensing, commissions and fees. 2 - things you pay because you expect them to increase your income.  If they meet either of these requirements, they're pretty much a lock as being deductible.  

Knowing the above, it's important to give one of my biggest pieces of advice - you pretty much should NEVER do something just because you expect it to help on your taxes.  Spend money only if you have to, or because it's the best idea for your business!  This has two benefits: 1 - you don't waste money on stupid s**t.  2 - chances are the deduction is legitimate.

So now comes the part you've been waiting for: What the hell can I deduct?  Here's a non exhaustive list, with some details, to get you started:

Marketing Expenses:  Business cards, website fees, MLS dues, lead generating expenses, posters, signs, sponsorships, commercials, advertising, pretty much anything you do to get someone to call YOU when they want to buy or sell a house.  As a non-tax aside, you need to evaluate these carefully, and talk to experienced agents to find the best of these.  Your commissions are big, but come infrequently.  You need to understand how much you spend for each commission so you can properly evaluate what works best.

Gifts and Referral Rewards:  Gifts to clients are generally limited to $25 per person, per year.  (That’s the deductible amount, you can give more.)  Be careful of referral fees.  You should have received more training on this than me to get your license, but I will simply remind you that there are varying rules from state to state, as well as RESPA requirements that restrict what amounts, how and to whom you may pay a referral fee, so, check with your senior brokers before paying these.  If the referral fees are legal, there are ways to deduct them, but talk to your tax professional about them.

Training, Education and Licensing:  Whatever you pay to maintain your ability to be an agent is deductible, as well as things you do to increase your skills, as well as what you are allowed to do in the field.  Classes, seminars, books and certificates mostly all qualify.

Insurance:  I'm not talking about homeowners insurance here.  I'm talking about ‘oops I screwed up and my client is suing me insurance’; or someone who's not my client.  Sometimes this is called Errors and Omissions Insurance.  If your state or agency doesn't require it, get it anyway!  Also, if you pay a rider to your car insurance for business use, the difference between that and regular insurance is deductible.  There is also a self employed health insurance deduction that allows you to deduct your health insurance costs if you have no other insurance source (if you can get insurance through your spouse's work this is a no-go.)

Entertainment Expenses:  Eventually you'll be with a client, or potential client, and pick up the tab for lunch, or dinner, or a stripper (don't do that - it's tacky - and questionable as a deduction).  Generally, if you expect the expense to result in a sale that makes you money, either immediately, or in the future (whether it ultimately does or not doesn't matter, as long as you expect it to) it's deductible.  I recommend writing the name of the client on the receipt, as well as a quick description - "house hunting", "referral source", "potential client" or something like that.

Travel Expenses:  These are a toughie.  People love conflating personal and business travel.  If you travel to Maine to visit family and see the lobster festival, and go to dinner with a client that is moving to your area, the trip is primarily personal.  You can deduct expenses DIRECTLY RELATED to the meeting with the client, but little else.  I recommend keeping business and personal separate.  You can visit a friend for dinner on a three day business trip, but don't do business for an hour on a three day personal trip.  Also avoid what I call BS travel.  Flying to Vegas to assess potential real estate markets is transparent vacationing disguised as business travel, especially if you spend 23 out of every 24 hours in the casino!  Be reasonable!  Go on trips that are going to increase your money-making potential.  Stay away from any others.  For legitimate travel, you get airfare, rental car, tips, taxis, laundry, internet and phone, as well as 50% of meals and any other reasonable and necessary expenses.  Travel assumes overnight trips away from your home area.

Cell phones, laptops and tablets:  Do yourself a favor, get a business only laptop, cell phone, tablet and/or computer.  It is simply too difficult to calculate expenses on a part personal and part business electronic device.  Don't share your business number with friends and family (other than wife and kids).  If you keep everything separate, the deductions are easy and legitimate.  If you don't, you have to establish a business use percentage, and worry about listed property rules - which suck!

Vehicle Expenses:  Keep a mileage log.  Let me say it again, unless you have a vehicle that is 100%, no s**t, total business and no personal use, keep a mileage log.  Don't worry about gas, repairs, oil changes, insurance or any other car expenses (except as discussed above under insurance).  There are other ways to track vehicle expenses, but mileage is the best.  Do track annual car taxes and finance charges.  The easiest mileage log is a notebook where you right the date, the trip purpose and the miles driven.  You will also need to know the total miles the vehicle is driven for the year, so write the odometer reading down every January 1st!  Mileage will be one of your biggest expenses, so keep track of it religiously!  10,000 miles of properly tracked vehicle mileage can result in $1500 of tax savings!

Home Office:  Set aside a space in your home that is 100% business use.  Never used for anything else, and regularly used for business.  This is where you keep your business records, your business computer or laptop, make your sales calls from and meet clients.  The tax term is regular and exclusive business use.  If you do this, you deduct a percentage of the household expenses - rent, interest, taxes, utilities, insurance, repairs, etc, based on the square footage of the office ratioed to the home square footage.  Expenses directly related to the office, such as a dedicated phone line; do not have to be ratioed.  You can also take a small depreciation deduction for the home losing value (let your tax guy handle this - it's a b**ch!)  

Employer Reported Expenses:  In many cases your employer is going to charge you for a number of different things like marketing and insurance.  They will generally track the expenses and then deduct them from your commission check when you make a sale or broker a purchase.  Virtually everything they charge you for will be deductible, but they will report the full amount of your commission on the 1099MISC at the end of the year, and then give you a report of what they charged you.  This simplifies things for record keeping, except that you need to make sure not to deduct something from the employer report twice by tracking it in your own records.

Depreciation:  Some items that you buy for your business, that have a useful life longer than a year will have to be depreciated over time rather than deducted all at once (examples include computers, digital cameras or office furniture).  There are many options for deducting it up front, but be wary of this, there are tripwires that can cost you if you dispose of something before it has passed its useful life.  Talk about these items with your tax advisor.

Record Keeping:  This is where the rubber meets the road.  Good record keeping will save you when it comes to tax time.  Your records don't need to be extensive, but they do need to be accurate and useable.  I hate double entry bookkeeping and would never recommend it as a tool for a Real Estate Agent.  I also have found that the various bookkeeping software programs are virtually useless when it comes to taxes.  They may help when it comes to managing the business, but they suck for doing taxes.  The best and easiest record keeping method I've found for Real Estate Agents involves a small notebook, a big notebook and an envelope or box.  The small notebook is for mileage, discussed above.  The big notebook is for every other expense (except employer reported expenses.)  You need simple columns set up: date, expense and cost.  You can add categories, but don't really need to, if you're unsure something's deductible, write it down and let your tax guy tell you if it's deductible.  The box/envelope is for receipts - just throw them in.  Really?  No sorting, categorizing or organizing?  No.  Simply put, your odds of ever needing them for an audit are slim to none.  Save the box, notebooks and tax returns for 7 years, and then throw it all away.  If you ever do get audited, there's plenty of time to sort through the box and organize it to match the notebooks - but why do it if it's not necessary.  If I'm doing your taxes I'm going to use the notebooks, and remind you that you should have a receipt for everything.  You don't have to prove things to me.

Separate Bank Account:  This one might be a little controversial, but I believe it's the be all end all of successful businesses.  Combined with record keeping discussions above, and budgeting discussions below, this will make everything easier.  Open a separate bank account for your Real Estate Agent business.  It doesn't have to be in a different name, just separate from your personal account.  If you use credit, get a second credit card that is exclusively for business (again, it doesn't have to actually be a business credit card, just one that you use only for business).  Put all Real Estate income in this account, and pay all Real Estate expenses out of it, or with the business credit card.  Pay off the business credit card out of this account.  The only expenses not paid out of the account are car expenses (especially gas) and home office expenses that will be divided based on square footage as discussed under home office above (utilities would not be paid out of the account, but office supplies and business only cell phone would).  The beauty of this method is that it simplifies budgeting as we'll discuss below, and it allows reconciling of expenses to make sure your notebook covers everything.  A good tax expert should be able to compare your account statements with your notebooks and know if you missed something (assuming you don't intermingle personal and business expenses).

Budgeting and Saving:  Now that you have an account that is separate for business, you can start thinking about budgeting.  Your income is going to fluctuate wildly, so you can use the business account to pay a "salary" to your personal account.  I recommend letting some money build up in the business account until you have a feel for your income level.  It will probably start small, but build up over time.  Once you have a good feel, you can pay yourself this salary.  The salary should be no more than 50% of your gross income or 60% of your net income.  You need to play around with it.  Start small and raise it if income exceeds expectations, but NEVER pay yourself more than 60% of net income.  Having a salary allows you to budget like you had a normal job.  Keeping a buffer amount in the account allows you to have a "salary" even during lean months.  By paying yourself a salary and saving the rest, if you have a really big month, you end up saving more, which in turn allows you to have the money to pay the tax bill that the big month will generate.  When you file your taxes, you should have plenty of money to pay the tax bill, and still have money left to maintain a buffer, and, if you're lucky, have the ability to pay yourself a bonus to your personal account for a big purchase or vacation!

Estimated Payments:  My advice is that you should use the budgeting advice above to pay your taxes.  You'll still need to make estimated tax payments if you're making good money, but you should pay the minimum required to avoid an underpayment penalty.  Your tax advisor will calculate them for you, but to explain simply: you need to pay at least as much as your prior year's total tax liability in withholding or estimated taxes to avoid a penalty (oversimplified explanation, but really all you need to know).  This is an easy calculation for your tax guy and he will set up quarterly payments and provide vouchers for paying them.  (The timing is a little weird.  You pay 4/15, 6/15, 9/15 and 1/15.)  You can also pay varying payments to try to avoid a tax bill, but it gets complicated, and the government won't pay you interest.

I hope you find this advice useful.  If you keep good records and separate personal and business expenses you'll make your tax guy's job easier, and pay the minimum in taxes.  If your tax guy sighs a lot while viewing your records, try harder next year.

If you are an experienced Real Estate Agent, help make this better by emailing me with any best practices you use, or anything I might have missed.  Feel free to leave a tip if this helps you save a bunch of money on your taxes!

As always, I’m available to answer questions at taxadvisor@email.com.  You might get a reply from a slightly different email address – that’s my phone.  It knows taxes better than I do so sometimes I let it respond!

Retiring from the Military? Tax Warnings!

Retiring from the military can be a wonderful time of life, but it is also a time of uncertainty, about jobs, residence, moving and other significant changes.  Once all these are settled, retirement can seem like everything you dreamed it could be - until that first tax return.  I've prepared dozens of newly retired military tax returns, and not one has had a happy outcome.  I'll grant that some people are ready for it, but most times they are not.  I've seen reactions that vary from, "That's all I'm getting back?", to, "I owe $5000?", to, "$25000! are you f**ken kidding me!"  It would not be an exaggeration to say that the several thousand dollar balance due is the most common result.

With this post I hope to provide information to mitigate the effects of retirement on your taxes (you can't prevent taxes, only minimize and prepare).  I'll start by explaining the changes you'll see, and then talk about what you can do.

Problem #1

ALL your income is taxable now.  That's right, no non taxable allowances, combat pay or other bene's.  You might have the same salary as when you were on active duty, but at least 20 to 30% more will be taxable.  While in the military, this had the effect of keeping most of your income out of the 25% tax bracket.  To dispel a common misconception, only the portion of income that is in the 25% tax bracket is taxed at 25%, the rest at lower tax rates, but we'll see why this matters as we discuss things in more detail...

Problem #2

Your new job doesn't know about your retirement income, and your retirement income doesn't know about your job.  This means that your wages and retirement will under withhold in almost all circumstances.  For an example, let's say you're married with two kids.   You put Married 4 on your W-4 form, and, while on active duty, this would be fine.  Now however, your job might put you a little into the 25% tax bracket, so they withhold just a little more than 15%.  Your retirement sees you in the 10 to 15% tax bracket, so they withhold just over 10%.  Together, they you're thoroughly into the 25% tax bracket.  If you make $20000 more than the bottom of the 25% tax bracket, that's $5000 that should be withheld but maybe $3000 actually gets withheld.  Those numbers add up!  This also is made worse if your spouse works.

Problem #3

Did you get a great relocation package?  They may have even covered the taxes for you (much of the package is taxable income.)  The problem is that the relocation package drove you right THROUGH the 25% tax bracket and into the 28% tax bracket.  Your retirement should be taxed at 25% but they're withholding 15%.  Say you get $40000 in retirement.  The withholding will be less than $6000, but you should have $10000 withheld.  Do the math: $10000 - $6000 = My tax bill is how much?!?

Problem #4

What happened to my $1000 Child Tax Credit?  What about my Education Credit?  And just what the hell is the Alternative Minimum Tax?  Military allowances tend to keep you from the income limitations that many people face.  If you have a kid in college, you could get a $2500 American Opportunity Credit.  If you have kids under 17, you should get $1000 each on your taxes, but both of those have income limitations that you might face at your new income. The Alternative Minimum Tax is a tax designed to make everyone pay their fair share, but more and more people face it every year.  A detailed analysis is beyond the scope of this post, but let’s just say this - it's BAD.

Problem #5

Wait, State taxes?  I never paid them before.  I know a lot of you are "residents" of tax free states, or are from states that don't tax military, but now, you reside where you work.  Most of those states are going to want their share of your money.  DFAS tends to not withhold state taxes unless you make them (though many states don't tax military retirement).  You should talk to your tax guy about the specifics of your state.

Problem #6

What do you mean I owe?  They withheld the tax on my Thrift Savings Plan early distribution.  DON'T DO IT - IT's A TRAP!  Seriously, unless you’re over 55 and not planning on working LEAVE IT ALONE!  Now is not the time to get clever about using it to buy a house and not having a payment.  Here's the deal:  They will withhold 20%.  10% of this will cover the early withdrawal penalty.  That leaves 10% in taxes.  I believe we covered your new tax rate above (hint - at least 25%.)  That means you are AT LEAST 15% under withheld.  Take too much out and you could be a s**t ton more under withheld.  Think - "I'm going to OWE at least $1500 for every $10000 taken out (not counting the $2000 they already kept.)"  That means, ignoring state taxes, you get less than $6500 of every $10000 you take out.  I don't care what the interest rate on your house would be - you're not making that back!  DON'T DO IT!!!!!

What to do:

So, besides not taking money out of your Thrift Savings Plan, what do you do?  You have several options:

1: Over withhold from your pension and your job

2: Make estimated tax payments (I’m not a big fan of this one.)

3: Save a large amount of money in the event that you have a large balance due

4: Do a combination of the first three (another is ignore and hope, but I can tell you that doesn't work).  

You should continue to treat taxes very conservatively until at least the end of your first full retired year.  Also, no matter which method you use, you should ensure that your withholding and/or estimated tax payments at least equal your tax liability from the previous year.  This will ensure you don't owe a penalty for underpayment.

To increase your withholding, you submit a W4 form.  The IRS likes to pretend that if you follow the instructions, everything will be fine.  This is bunk.  The W4 instructions are the most useless instructions of any IRS form.  My advice is to simply select Single and 0 for each and every job you have, as well as your retirement (you can do this online via Mypay for retirement.)  After your first full year of retirement, if you get a big refund, you can readjust your withholding.  I must warn you though; even this might not be enough.  You should strongly consider having a very conservative budget until you are sure what your tax situation will be.  Set aside lots of money just in case you owe.

My best advice is to call your tax guy after you start the new job.  Give him or her detailed information about your new income (retiree statement and pay stubs are best) and he/she can run the numbers for you.

Feel free to contact me with questions at: taxadvisor@email.com