What Can You Learn by Reviewing Your Tax Return?
Your tax return is more than just an annual obligation—it’s a valuable tool that can provide insight into your financial health and opportunities for future planning. By taking the time to review your tax return, you can gain a better understanding of your tax situation and make more informed financial decisions. Here are some key areas to examine:
Your Marginal Tax Bracket
Your marginal tax bracket determines the tax rate you’ll pay on your next dollar of taxable income. It’s essential to know which bracket you fall into because it affects decisions such as whether to defer income, contribute to tax-advantaged accounts, or harvest capital gains.
For example, if you’re on the edge of a higher tax bracket during the current year, you may want to explore strategies to reduce your taxable income, such as making additional contributions to your pre-tax retirement accounts. Conversely, if you’re in a lower bracket than usual this year—for instance, due to a temporary dip in income—it may be an excellent time to accelerate some income or consider a Roth conversion.
It’s also important to remember that you have a marginal tax bracket for ordinary income and for long-term capital gain income. You’ll want to be aware of both types of income brackets.
Your Effective Tax Rate
While your marginal tax bracket tells you the rate applied to your last dollar of income, your effective tax rate represents the actual percentage of your total income that you paid in taxes. You can calculate this by dividing your total tax liability by your total income.
Understanding your effective tax rate is helpful when determining whether your tax planning is functioning as expected. It is a better measure of the overall effect of income taxes on your income than your marginal tax rate. This is especially true when a significant portion of your income comes from long-term capital gains which do not affect your marginal tax rate on ordinary income.
Your effective tax rate is also an indicator of how efficiently your income is meeting your needs. For instance, were you taxed on dividends and interest that you didn’t need this year and could have been in a tax-deferred account? This is an example of asset location (which is different from allocation) and income planning that can help you keep more of what you make.
Standard Deduction vs. Itemized Deductions
Your tax return will show whether you took the standard deduction or itemized your deductions. Knowing which method you used—and why—can help you optimize your tax strategy going forward.
If you took the standard deduction, it generally means your eligible itemized deductions didn’t exceed the standard deduction amount for your filing status. However, if you were close to itemizing, you might consider strategies like bunching charitable contributions or prepaying deductible expenses in one year to push your total deductions over the threshold.
If you itemized, take a close look at what deductions you claimed. Were they primarily from mortgage interest, state and local taxes, or medical expenses? Were the deductions ongoing expenses or just temporary? Understanding where your deductions come from can help you plan for future tax years and determine whether making changes—such as paying off a mortgage or adjusting charitable giving—could affect your tax situation.
Did you Qualify for Tax Credits?
Tax credits can be valuable because they reduce your tax liability dollar-for-dollar. Reviewing which credits you qualified for—and whether you missed any—can help you plan for the future.
It’s important to take the time to understand which credits may be available to you. Many credits have income level requirements. Others may have spending requirements. Be sure to either understand the available credits or work with a tax preparer who will try to understand your situation to the extent that they can determine your eligibility for tax credits.
Did You Owe a Penalty?
If you owed an underpayment penalty, it could be a sign that you need to adjust your withholding or estimated tax payments. The IRS typically assesses penalties when you don’t pay enough tax throughout the year through withholding or quarterly estimated payments.
Reviewing why you owed a penalty can help you avoid similar issues in the future. If your income fluctuates, you might consider adjusting your estimated tax payments or increasing withholding from your paycheck. If you experienced a significant financial change, such as a large capital gain or self-employment income, proactive tax planning can help prevent surprises next year.
The Bottom Line
Your tax return holds valuable information that can guide your financial decisions. By reviewing it carefully, you can identify ways to optimize your tax situation, reduce your liability, and plan more effectively for the future. If you’re unsure how to interpret your return or how to implement tax-saving strategies, consulting with a financial advisor or tax professional can provide additional clarity and guidance.
This article is intended to be educational and thought-provoking rather than financial, legal or tax advice. When we work together in a financial planning engagement, we discuss your unique personal situation and your unique goals. During our financial planning process, we examine these factors and many others to determine appropriate financial strategies for YOU.