In honor of tax day I thought I'd revisit some thoughts I've had before on the truth behind the tax code -- a look at what kind of behavior the government encourages through the tax system, and what kind of activities 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. The IRS also offers a Volunteer Income Tax Assistance program, typically through libraries or community centers, that gives free tax help to people making less than $54,000 a year. There's also a Tax Counseling for the Elderly program offering help focused on pensions and retirement-related issues.
All this is convenient, of course. But when you rely on someone else to do your taxes you get no understanding of how the tax code really works -- and what it can do for you, or to you. Meanwhile, a lot of people use electronic services such as Turbotax. This is kind of like doing it yourself, but the electronic process still does hide some details of the tax system and how they affect 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. What I mean is that 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've learned doing my own taxes.
1. The Federal tax system penalizes workers. Not only do you pay the highest rates on 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 -- after a worker has crossed the salary threshold of $128,400 a year, the government exempts the rest of earnings from the payroll tax.
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 income a worker uses to pay for health-insurance premiums -- but ony if the medcal insurance comes through the workplace or through a 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, your grandchildren, 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, tax 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.