Monday, April 17, 2017

The Truth Behind Your Taxes

     The deadline for filing our taxes is usually April 15. This year April 15 falls on a Saturday so the deadline is pushed to Monday ... but Monday is a holiday in Washington, DC (Emancipation Day), so Federal taxes are due on Tuesday, April 18.

     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. 

     5. Or owning a business. Again, many tax breaks are available to people who work for themselves, such as deductions for "travel and entertainment." But there are drawbacks as well. For one, you have to pay both the employer's and the employee's part of the Social Security tax. And the tax-filing process can be confusing and complicated, requiring obsessive record keeping, mind-numbing calculations ... and usually the expense of paying a professional accountant.

     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.


Stephen Hayes said...


I recently learned something about taxes you might want to pass along. People should do some research to find out what the inheritance tax is in their state. I learned in the nick of time that Oregon has a lower inheritance rate than some states. By getting my late mother's estate under a million dollars before she passed away, we saved over a hundred thousand dollars in state inheritance tax. The Fed. tax is much higher.

Anonymous said...

I feel that cash is king in a recession, so I like having lots of cash in the bank. It's better than owning investment real estate, which is not liquid. Hard to sell real estate during a recession.

retirementreflections said...

Very clear and timely post, Tom. Makes me wish you were Canadian and could explain our tax system just as clearly!!

Anonymous said...

The sad part here is that taxes must continue to go up AND Congress has to cut spending in all categories.

DJan said...

My taxes are prepared by AARP volunteers at the Senior Center. It doesn't take them very long at all to do it (we're easy) and they also don't charge us. I like it! :-)

Olga Hebert said...

I pay my taxes and pay an accountant to tell me the damages. His fee is worth the time and aggravation doing my own taxes saves me. And he gives me good advice along the way.
I always did our taxes when I was married to my first husband. Since our thinking about financial matters was a big negative issue in that relationship, I associate the process of doing the taxes on my own a major factor in my depression, craziness, and subsequent divorce. Honestly, if someone offered to pay my taxes for life if I would prepare my own return each year, I would not take him/her up on the deal.

Heidrun Khokhar, KleinsteMotte said...

And if you invest outside of US or work outside you pay taxes on that as well. Many people who have ties to their homeland after immigrating have failed to learn that the IRS is now able to find our about foreign accounts. And money made is declarable in US for any US citizen. A US citizen working as MD in Canada has to pay US taxes as well as local ones. And for that it is best to have an accountant to get the best , lowest tax rates.
We have various tax deadlines depending on being employed or self employed. Employed are due April 30; self employed June 15. Then there are tax deadlines for businesses and they vary too.
I wonder how much actual income anyone makes with all the multiple taxes that are now imposed?

Anonymous said...

Until my husband retired (11 years before I did), I did my own taxes. I always bought a new book each year that told me of the changes since the previous filing. In 1981 or 1982, my Federal tax submittal ran to 26 pages. Then, I had to file State tax forms in two states! I took it as a challenge and wouldn't have dreamed of letting anyone else do my taxes as I felt they wouldn't care as much about them as would I.

Now, husband uses TurboTax to file our joint tax forms and I get the ineluctable pleasure of listening to him kvetch about how complicated my part of the taxes is. And that's after selling off some of the investments about which he complained the most. Oh, joy. I would go back to filing separately and doing my own, but that might be seen as an assault on his feelings.
Cop Car
P.S. Something else that no one points out about the various forms of deferred compensation (IRAs etc) is that the income is taxed at the normal income rate when you take distribution. If one had paid taxes on the original money, invested it 100% in the stock market, one would pay the reduced capital gains taxes. At least, that is currently true.

Anonymous said...

P.P.S. I should have said that one would pay the reduced capital gains taxes - on the GAINS. And there would be no taxes due on the "basis" of each investment.

Tom Sightings said...

Yes, Stephen, state taxes are certainly another issue; and what some states are telling us is ... leave. Cop Car, good point; would be interesting to see if there are any studies comparing saving in an IRA and compounding tax free, then paying the higher tax, vs. paying lower tax now but compounding on lower after-tax basis. Might make a good subject for a blog post ... but for somebody else since it's too much of a deep dive for me.

Bob Lowry said...

I couldn't handle the tax load without Turbo Tax. I am doing my taxes, my parents' estate taxes, and helping one of my daughters with hers. Like you, Tom, I used a professional a few times, but they are not always right and are way too expensive. For the cost of a piece of software, I believe I am getting the same breaks (or not) that an expensive CPA would charge me.

I probably shouldn't say this, but after all these years, including 25 years of running my own business and deducting a lot of expenses, I have never been audited.

Janette said...

Where is the piece of wood you are knocking on Bob? We haven't been audited either.
We have only had our taxes prepared by someone else once. After reviewing the forms (before signing them) and finding more then ten errors, we never had them prepared by someone else again. Where do they get those volunteers anyway? I am sure most are not actually qualified to do MY taxes. For the last ten years my taxes have been downright simple. God bless IRAs.
Can you still put money into a 529 for your own return to college? Inquiring minds would like to know. Who am I kidding? I don't really want to return to school.
And Stephen, thanks for reminding me to look at our wills. Our change of states could change how things are worded for death taxes. Uggg! Another taxable event to think about!

diego78 said...

Truly very informative share. I too want to be financially secure but haven’t started with savings yet. However, want to start as soon as possible as aiming for an early retirement. Searching out good Las Vegas certified financial planners for consultation.

Gowri said...

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