Dan writes in with the following question regarding tax refunds and withholding:

I am a married sailor with two kids. I still have taxes taken out as though I were a single man. The reason I do this is because I lack the discipline to handle the extra money each pay check. It’s kind of nice to overpay every year and get the lump sum back from the government. Then my wife and I pay down some of our debt and move on. We don’t splurge with this money.

I’ve been told many times that I’m just giving the government an interest-free loan and that I should pay more down on my debt each month instead of once a year, but I’d like to get your thoughts on this.

There have been many debates about the practice of withholding too much in taxes to receive a large refund at the end of the year. I tend to agree with others who have advised that this is sort of like allowing the government to use your money, tax free, throughout the year and then return it to you at the end of the year.

A better way to think about it is to examine the opportunity costs associated with getting a large refund. Let’s assume your tax refund last year was $6,000. That works out to about $500 a month too much in taxes withheld from your pay.

If you dropped that $500 a month in an online savings account averaging a 3% yield, you’d have $6,100 after the first year. That’s $100 you’re missing out on each year just by having the government hold your money. But that’s not all.

If you used some or all of that money to pay down debt throughout the year, instead of waiting until the end of the year, you would likely pay less in interest charges, too.

There is also the issue of security. You didn’t mention an emergency fund in the mix, but this $500 a month would go a long way towards building a buffer between your family and the next financial emergency. If that same money is tied up in taxes, you won’t see it until February, and it won’t be available to help cover those inevitable expenses all households experience.

Having said all of that, I can appreciate the idea of using taxes as sort of a “forced” savings account. Often times we have to use things like this to protect ourselves from ourselves. If you will likely blow the $500 a month instead of socking it away, or using it to pay down debt, then over-paying taxes throughout the year and counting on a big refund might make sense. Still, I’d look for a way for you to control that money yourself and get some benefit from it.

I use TurboTax to complete my personal and business taxes.

I made the mistake yesterday of sharing a link with Twitter followers indicating the Cash for Clunker rebate would be treated as taxable income. Astute followers quickly pointed out that the link I shared was from a site spreading a false rumor about the Cash for Clunkers tax implications for buyers.

Instead, I should have checked out the C.A.R.S. government-run site, which provides the following answer to the burning cash for clunker tax rules question:

Is the credit subject to being taxed as income to the consumers that participate in the program?

NO. The CARS Act expressly provides that the credit is not income for the consumer.

While I wasn’t fond of the Cash for Clunkers program from the get-go, I concede that it spurred on many more sales than I expected. In fact, it might be the first program with any real stimulative effect since the passage of over a trillion dollars in bailouts and stimulus packages.

It seems Americans are always up for a $4,500 rebate. However, the suspicious consumer in me wondered if the manufacturers suggested retail price (and dealer price) didn’t go up in advance of the deal. After all, an increase in consumer buying power, especially when generated artificially as in the case of a government rebate, is often followed by higher prices.

I also wondered if consumers would be trading in cars for a rebate when they could have received much more money via a private sale. But that is always a risk when trading in a car at a dealership. The dealer is not going to give you top dollar because he has to leave a little room to make that when he resells the car (not a problem under Cash for Clunkers since they were ordered to be destroyed) he turns a small profit, or at a minimum breaks even.

Debt is also a concern. How many people trade in a paid-for clunker for a shiny new car with a big auto loan? It might be better for the environment, but is it better for your family finances? That remains to be seen. Might be a good time to be in the repo business, though.

All this is water under the bridge now, as the Cash for Clunker program ended Monday night. However, it sure would have been quite the surprise to learn Cash for Clunker tax rules meant the rebate you received was treated as taxable income. From my web research, it sounds like there still may be an issue for dealers, and even buyers may not be completely out of the woods when it comes to state taxes on Cash for Clunkers. At least it appears Cash for Clunkers will not negatively impact buyer’s federal taxes.

Additional Resources:

• Cash For Clunker Payments – Tax Rules
• Cash for Clunkers Tax Rules – The Truth
• (More) Cash for Clunkers Tax Rules
• Does Cash for Clunkers Affect Your Taxes?
• Tax Rules And Consequences Of The Cash For Clunkers Program

With April 15th fast approaching, and a couple things lining the calendar for the next couple weekends, I thought I would bite the bullet, fire up TurboTax, and finalize my 2008 taxes.  Besides, the weather was dreary out and there wasn’t much else to do.  I ran through estimates earlier in the year, and thanks to a bit of self employment income, had already ruled out the chance of receiving a tax refund.  So I set things aside determined to revisit them in time to meet the tax filing deadline.  I learned a few painful lessons.

Self Employment Tax

Tax year 2008 was the first year I had any self employment income to speak of.  It was also my first introduction to the self employment tax.  When you work for an employer, you split the tax rate for social security and Medicare.  But when you are in business for yourself you pay both sides of the equation – 15.3% (12.4% for social security and 2.9% for Medicare).  It may not seem like much, but the self employment tax rate paid on top of your normal income tax rate can make for a large tax liability.

Estimated Tax Payments

Speaking of large tax liabilities, if you plan to have to pay more than $1,000 or so in self employment taxes, it is a good idea to make estimated tax payments on a quarterly basis to avoid underpayment penalties.  Think of this as you withholding from your own income, similar to the way companies withhold tax payments from an employee’s paycheck.

Estimated tax payments may be made free online using the EFTPS (Electronic Federal Tax Payment System).  Once your enroll at the site you are mailed a PIN to the address on record with the IRS.  The pin takes a couple weeks to arrive, so plan accordingly.  Once you have the PIN you may create an online profile/password at EFTPS and you are on your way.

To simplify things a bit, I set aside 30% of my self employment income (freelance writing, ad sales, etc.) in a sinking fund at a designated online checking account.  When the time comes to make quarterly estimates, I simply transfer money from my “Taxes” sinking fund using the EFTPS.

*Note, 30% may be too high or too low for your specific situation.  It’s a good idea to review last year’s taxes and determine your tax liability for self employment income to come up with a starting amount due for this year.  Be sure to increase or decrease that amount based on your revenues.

Improve Your Record-Keeping System

A good record-keeping system is vital to the success of any entrepreneurial venture.  After all, without tracking profits and losses, how do you even know if what you are doing is worth the effort?  It is also a big help around tax season.  Even if all you do is create a file folder labeled “2009 Taxes” and toss all receipts and income statements there, it’s a start.

Those of us with self employment income have legitimate opportunities to deduct expenses from our income.  For instance, as a blogger I can deduct things like hosting fees, domain registration and renewal costs, graphic design fees, etc.  This is a short list of the many potential tax deductions for bloggers.  Use only those that apply to you, and be sure to keep up with your receipts throughout the year to prove the expenses were paid.

Consider Hiring a Professional

Don’t take my word for it, consider consulting a tax professional, particularly when things get complicated.  A CPA, or someone specializing in taxes for small businesses, will help guide you through filing the appropriate forms, help determine which expenses are deductible from your income, and help you avoid any potential audit red flags.  I am a do-it-yourselfer by nature, but readily admit I will pay for tax advice when necessary.  Considering the consequences of an audit, penalties, etc, it might be the most frugal thing you could do.

Since originally writing this post I picked up a copy of Quicken Home and Business to manage my business finances. It’s been a life saver!

The following guest post is from Trisha Wagner.  Trisha is a freelance writer for DepositAccounts.com, where you can compare rates from dozens of banks in one place.  She writes regularly on the topics of personal finance and saving money.

It happens every year when tax time rolls around people scramble to find ways to make filing their taxes easier and limit the damage to their wallets.  What many people forget is by the time you file your taxes there isn’t anything you can do to change last years information, however you CAN take note and make changes now that will help you save money a year from now.  The following basic tips can help you make the changes needed today and at the end of the upcoming year to take the bite out of your next tax bill.

• Deductions- Are you claiming all the deductions that you are entitled to?  Many people mistakenly claim the standard deductions without fully investigating what they specifically may qualify for in their personal situation.
• Keep track of all business relates expenses and receipts- If applicable track all expenses related to a home business.  Get into the habit of doing this systematically, weekly or monthly to ensure you don’t lose receipts or track of what you spent your money on as time goes by.
• Remember donations to charity- Ideally you should be donating to charities that have a personal meaning to you with the added bonus of being about to lower your taxable income at the end of the year.  Remember to keep receipts for charitable donations.
• Take all applicable tax credits- Are you getting all the tax credits you are eligible for? If you have children under the age of 17 you may qualify for a $1,000 tax credit.  There are other tax credits for various things such as adopting a child, buying your first home, earned income tax credits, saver’s tax credit, child and dependent care credit and education-related credits.
• Tax-free investments- If you are looking for a tax friendly investment you might consider tax-free municipal or government bonds or other similar investments.  The returns are not as high as other investments but can be good for a high-income individual.
• Tax-free gifting- If you are have significant assets you may give up to $12,000 away tax-free for each individual you choose.  Typically this works well for retirees who may want to gift money now instead of bequeathing it to someone in their estate.
• Review Tax Returns- Specifically Form 1040 for missed tax opportunities from the previous year.  You should pay special attention to the Taxable Interest, Tax-Exempt Income, and Dividend Income lines.  Your tax bracket has critical affects on the effective yield of your investments.
• Check your work twice- Taxpayers could save millions of dollars each year if they took the time to double-check their work.  Error in tax preparation and on tax returns can be very costly for taxpayers.

It is important to remember that your financial situation, the economy and the tax laws change from year to year so it is important to keep up to date on tax information to ensure you are covering the basics each year and filing your taxes in a way that benefits you the most.

In the next week or so taxpayers should start seeing notices from the IRS in their mailbox. IRS notices have a tendency to cause panic in the hearts of their recipients, but not to worry. The notices are simply a “friendly reminder” from the IRS that this year’s economic stimulus payment eligibility is based on your 2007 tax filing. Those of you who delay filing for the 2007 tax year will likely see a delay in the first round of rebate checks, which should start rolling out in May.

The subject of what to do with these tax rebates has been written about in the personal finance community ad nauseam. So instead of piling on, I thought I would share what we plan to do with our tax rebate. According to most estimates we should receive $1,800 – $600 for me and my wife, and $300 for each child. Initially, I planned to use the entire $1,800 to pay down debt, but things have changed over the last couple months.

I desperately needed new tires on my old beater because steel thread was showing through and a blow out was probably imminent. Our emergency fund took a hit after finding the truck also needed new ball bearings and an idler arm. We’ll use the first $600 to replenish the emergency fund from the cost of repairs, labor and new tires.

My wife has been diagnosed with a problem with her knees, and I’ve got a bad ankle. Both our doctors have recommended a stationary bike to rehab our knees/ankle, respectively, and as a strategy for me to drop some weight. Jogging, and even long-distance walking, is out because I can’t take the pavement pounding. We’re currently looking at picking up a used recumbent bike in good condition from Craigslist or local advertisement. Prices vary, but we’ve set aside a couple hundred dollars from our refund for this purpose.

With the remaining $1,000 or so we plan to beef up our emergency fund and pay down debt. We plan a 50/50 split, putting $500 towards both efforts. I’ve always thought the $1,000 baby emergency fund suggested by Dave Ramsey was a bit anemic, considering larger repairs or replacement appliances can easily top that amount. Bumping up to $1,500 makes me feel a bit more comfortable and motivates me to really stretch to make large debt payments each month.

Have you locked down your plans for the tax rebate?