In honor of tax day I thought I'd update an article I wrote for the U. S. News Retirement website a couple of years ago. It gives us a brief analysis of what kind of behavior the government really encourages through its tax system -- and what kind it actually penalizes.
Most people do not do their own taxes. They throw up their hands, decide it's too complicated and run to an accountant or H & R Block. A lot of people use electronic services such as Turbotax. This is kind of like doing it yourself, but the electronic process does hide some details of the tax system and how it affects you.
I have always done my own taxes -- except for a couple of years when I tiptoed into an accountant's office and found out they don't necessarily do a better job, and they charge you an arm and a leg for the service.
While it does take some time, and the process is not entirely painless, doing your own taxes can provide an educational experience. I'm not talking about practicing your arithmetic skills. I mean you find out what the government is really encouraging you to do (despite what it says) and what it really penalizes. In short, you find out how the world works.
Here are ten lessons I learned in doing my own taxes over the last few weeks.
1. The Federal tax system penalizes workers. Not only do you pay the highest rates on the income you earn, but you also pay Social Security (aka payroll) tax of about 7% on your salary. Your employer pays an additional 7% -- which means, at least theoretically, they could pay you 7% more if they weren't giving that money to the government. But wait ... the government likes you if you make a lot of money -- once you earn more than $118,500 a year (or starting in 2017 more than $127,200), the government no longer takes its cut of 14%.
2. Invest in the stock market. Some of the money you make from capital gains -- the profit from selling a stock for more more than you bought it for -- doesn't get taxed at all. The rest is taxed at a lower rate than the money you make on your job. Most stock dividends are taxed at a lower rate as well.
3. You're a sucker if you have a savings account, or buy a bond. The interest rate you receive from a corporate or government bond, or a regular savings account, is as low as it's been in decades. It's below the rate of inflation, which means you are actually losing money. The IRS doesn't care. It taxes the little bit of interest you earn at its regular rate, meaning you lose even more money.
4. The IRS can't make up its mind about real estate. Real-estate investors can take advantage of certain tax breaks, such as depreciation; but are excluded from others. Rental income is taxed at the full rate, as opposed to stock dividends which get preferential treatment. Bottom line: Investing in real estate can be a good deal, but it's not for everyone.
6. But it does want you to save for retirement. The government offers a wide (some would say overly complicated) array of options -- such as the IRA, the Roth IRA, the SEP IRA, the 401(k) plan – which allow you to escape, or at least defer, taxes on your retirement savings.
7. It wants you to get health insurance through your business, but not on your own. The IRS doesn't tax the income you use to pay for health-insurance premiums, but only if you get medical insurance at your workplace or through your own business. If you buy medical insurance on your own, including Medicare ... no tax break for you!
8. The government will cut you a break if you're sick, but only if you're really sick. You can deduct out-of-pocket medical expenses, including dental expenses, that exceed 10% of your income, or 7.5% of your income if you're age 65 or over.
9. The government wants people to go to college. The silver lining to the ridiculous cost of higher education is that there are several ways to deduct a portion of college tuition on your Federal tax form. Many states offer tax breaks for educational expenses as well. The 529 College Savings Plan is a relatively simple and easy way to avoid taxes on money you put aside for college ... for yourself, or anyone else in the family.
10. The government doesn't want you to do your own taxes. The Federal tax code reportedly runs 70,000 pages or more (people can't even agree on how long it is), and details all kinds of rules, regulations, breaks and penalties. Plus, there are many more pages at your state level. The whole process is way too complicated for the average person. The IRS really wants you to pay an expert, who is more likely to get it right, and who will file electronically, saving the government (but not you) a little bit of money.