Clients often expect that I know secret tax rules that will create wondrous deductions, credits and refunds on their returns, no matter what they’ve done financially during the year. They are disappointed when I tell them that there is generally very little I can do once the fiscal year is over, nor are there any “secret” deductions I can get them that most people don’t know about. It really comes down to the numbers they give me, which generally means how much they earned at their job or business, how much they withheld or pre-paid in income tax, and a handful of other things like the number of dependents they have, and how much they paid in itemized deductions like mortgage interest, state income taxes, and charitable donations. “There is no magic to this,” I tell them.
And yet…there is one truly magical tax deduction that few people know about, and which never ceases to amaze me. It can seem like a conjuror’s trick when you see the result on your tax return. Not just pulling the proverbial rabbit out of a hat; more like pulling a horse out of a thimble.
To illustrate, I’m going to use the real numbers on a real tax return for a couple who recently filed with me. The only things I’m going to change are their names. Let’s call them Larry and Cathy.
Larry and Cathy had combined income of $95,359 that included their prior year state tax refund and a little taxable interest, but consisted mostly of their salaries (both are employed). They have no dependents living at home, their kids having long since moved out and started their own families. Fortunately, they were able to itemize over $28,000, thanks mostly to their mortgage interest and some generous charitable donations. They also withheld more than they owed in income tax, and for that reason they had a small-ish federal refund of $632.
But then Larry and Cathy did something very smart, like members of a magician’s audience who know how the trick works. They decided to contribute that $632 refund to their IRA and asked me to make that adjustment to their return. There is actually a line on Form 1040 that allows people to deduct IRA contributions from their reported income, even if the tax year is already over.
Let’s look at what happened next to Larry and Cathy’s return. Their income of $95,359 was adjusted down to $94,727. Their tax went from $7,999 to $7,909, and without changing the amount of their withholding (which couldn’t be changed because the year was already over), that $632 refund became $722.
I know I sound like a tax geek (and I am!), but that little trick just dazzles me. Take your refund, contribute it to your IRA (or start one if you haven’t got one already), and your refund gets bigger. Presto change-o! You don’t even have to come up with any extra money, although if you had the scratch and could bump the contribution to, let’s say, $2,000, your refund would jump to $932. You can play this game for quite a while and watch that refund get bigger and bigger as you add it to your IRA. And it happens even when the tax year is over, right up to April 15 if you want.
How does it happen? A real magician never divulges how the trick is done. Lucky for you I’m just a tax preparer (wink!). The obvious part is simple enough to grasp. Any reduction to your taxable income is a reduction to your tax, and increases your refund (or at least decreases your tax due if you didn’t withhold enough to get a refund). That’s fun to watch but it isn’t all that mysterious.
But the magic part is that you can do it even after the tax year is over. Why? Well, lots of tax provisions exist in order to encourage things that we value as a society, things we have decided are for the common good. Children, home ownership, education—all are encouraged by certain benefits built in to the tax code. Saving for retirement is one of those things, and was deemed so important that using your tax refund to pay for it seemed like a good idea.
Which it is. Turns out, there is a little magic to doing taxes.