Friday, April 13, 2018

The Truth About Taxes

     The deadline for filing taxes is usually April 15. This year April 15 falls on the weekend so the deadline is pushed to the 17th. This coming Tuesday, in case you've forgotten.

     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.

     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 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.


Terra said...

You make some good points here. I noted that this year the tax rate for me went down and the standard deduction went up, so that is a good news for me. Maybe a flat tax (with maybe 3 or 4 tax bracket rates) would be better and getting rid of those 70,000 pages of tax code would be great.

Julie said...

Nope, the deadline for filing taxes this year is Tuesday April 17th. That's because April 16th is Emancipation Day in Washington D.C.

Anonymous said...

You make some excellent points! My husband and I are amazed at the percentage difference in taxes we pay now that our income is from investments, not from work. We aren't complaining, but, somehow, it doesn't seem quite fair. My understanding is that taxes will be getting more confusing next year... as soon as the powers that be figure out what the heck they are doing (or not). Fortunately, we sent our returns in well before the April 17 deadline so we are done for this year.

DJan said...

We have incredibly easy tax returns to file, and we use the volunteer AARP people at our local Senior Center. It takes them about ten minutes and then we get an electronic refund. We spent it already. :-)

Tom Sightings said...

Oops, Julie, you are right . . . another day for us procrastinators to, um, procrastinate.

Jono said...

Very good, Tom! Will you address the question of what the government does with all that money in a simple, easy to understand way and why it never seems to be enough? Just kidding! Thanks for the analysis.

Tom Sightings said...

I dunno, Jono, but it's been said that the U. S. government is nothing but a well-armed insurance company.

Olga Hebert said...

The IRS gets my full cooperation with #10. You said, " But when you rely on someone else to do your taxes you get no understanding of how the tax code really works" Well, that's the way I like it. I can't even force myself to look at the completed form once the accountant completes it. I just write the checks and send them off. And I always have to pay taxes so I why would I put myself through the additional agony of figuring out how much by myself?
I asked what kind of major tax break I can expect next year, courtesy of the Republican Congress. My personal deduction will go up but something else will go down and so I can expect to owe as much as usual. Guess I am not rich enough or Republican enough to get a tax cut.

Anonymous said...

Hubby uses TurboTax and has never been audited. So glad he is an accountant, who passed the CPA exam long ago.

Anonymous said...

We do our own taxes (file electronically using a canned program) because no one cares as much about doing them right as do I. Cop Car

Laura Benjamin said...

A little detail about 401(k), 403(b) and those other retirement savings deals that have you investing for retirement with before-tax dollars just occurred to me reading this. We save our pre-tax contributions which usually don't amount to enough to change our tax bracket while working. We don't pay the capital gains taxes at lower rates while we are investing. We also pay whatever fees those programs charge us for the duration. We then get told by the IRS, when we come of age, how much income to take out of these little jewels. And then we pay the higher rate of tax on earnings and capital gains, as if this were all earnings.

Snowbrush said...

Peggy has done our taxes for years. Even after software came out, she continued to do them herself on paper. She still does them herself, but then takes them to an AARP volunteer for validation and submission.

Rebecca Olkowski said...

I've always been a freelancer so my taxes are too complicated for my right-sided brain. My tax guy has usually made it look like I earn nothing but this year I got nailed because I made $1,000 too much. Sometimes I think I would be better off living on just my nothing SS and a tiny pension and living in a yurt in the middle of nowhere.

Linda Myers said...

I've done our taxes forever. By hand at first, then by TurboTax when it came out. What I forgot, for last year, was if you take money out of investments (an IRA, say) to pay off a student loan, you get taxed on the money you made in those investments. How could I forget such a thing?

The IRS will probably be happy with our check. But I'm not.

Victoria Estep said...

We do our taxes on Turbotax. My daughter and I sold Lularoe for a year and a half and it killed us on Taxes. I made $6000 but it cost us $3000 in taxes.

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Jose said...

Tom Hi, good points, except one: doing the taxes by yourself (and/or with the help of a turbo tax or similar) can be a "dangerous" project. A good CPA (and the stress on good...) should look at your whole situation and either find missing deductions and/or prevent you from making moves in the future that might be costly tax wise (not to mention that sometimes they might advise you on supposedly unrelated matter. I'm slightly biased, being a CPA myself, I usually don't do personal income taxes as it is not worth the hassle and the fees charged are ridiculously low, in some cases, but I see the value I bring to the table to the few people (friends, family and some business connections) I prepare the taxes for.
Great blog!
Best regards