SECTION 3.5: Taxes
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Income taxes are mysterious and scary to many of us. Sales taxes are easy to understand, even if they do cost us a fabulous amount of money over time. Most of us pay significant income taxes on the state and federal level. Some states are so prolific in other ways that they do not need to charge residents state income taxes to keep afloat. All other things being equal, these are the ideal states in which to live. No matter where you go, you will likely be liable to pay federal income taxes. Because you don’t have to pay federal taxes until your income rises above a certain level, many students have never paid a substantial amount of income taxes. This is a big part of the “pay stub shock” we discussed earlier. The costs are so substantial and so damaging to your wealth building potential that you should commit to learning the basics.
The first thing you should understand about federal income taxes is that you only own taxes on your taxable income, not your total income. Certain things can be removed from your total income before taxes are calculated. Examples of these are “pretax” benefits that your employer takes out of your paycheck. These reductions in your taxable income can be important for several reasons. The first is the obvious fact that if you aren’t paying taxes on the income, you are saving money.
There is a second source of savings when you consider that the United States uses a progressive tax system; the more you earn, the bigger the percentage that you have to pay. This is done in tax brackets, and money within certain ranges is taxed at different rates. Money that can be removed from your taxable income comes “off the top,” and you don’t have to pay taxes on it at your highest tax bracket. Your taxable income also has an impact on how certain deductions work for you. If you make above a certain amount, for example, you cannot claim the total amount of your student loan interest. We see, then, that we want to take all of the deductions that we can get because they will potentially save us money in several different ways. You can get deductions for having children, giving money and goods to charity, paying for health insurance, paying student loan interest, paying mortgage interest, and many other things. You have to prove all of the things that you claim as deductions at the end of the tax year, so you will need to organize and store many different documents.
I am a big advocate of “Do It Yourself,” but when it comes to taxes, you will be better off hiring a high-quality tax advisor, such as a CPA. These professionals can help you develop a strategy at the beginning of the tax year, which can help to maximize your deductions. If you are a small business owner or an investor (outside of your retirement account) then hiring a professional becomes a “no-brainer.”
In addition to “tax deductible” expenses that you can subtract from your total income before computing your tax liability, there are tax credits that subtract whole dollars from your tax liability. These can have a huge impact, and you want to go every possible one with your tax professional. Small business expenses and child care can fall into this category.
You will want to watch your withholdings carefully over time, and adjust them as your life situation changes. Withholdings are funds that your employer keeps out of your check and sends to the IRS on your behalf. The idea is to break even and pay all of the taxes you owe, but no more. Many people intentionally overpay these taxes so that they get a tax refund. Always keep in mind that a tax refund is not a gift from your Uncle Sam; a refund is you getting your money back. You could have done a lot of different things with that money over a year, such as investing it and earning interest. You forgo that possible interest income when you give Uncle Sam an interest-free loan for an entire year. Still, if your psychology means that you can do more good with a lump sum refund (paying off debt, making investments, etc.) then don’t let the detractors dissuade you from doing that. When it comes to building wealth, we are often our own worst enemy. Do whatever it takes to get yourself to do the smart thing, even if it isn’t mathematically optimal.
It is amazing that so many people are willing to pay a dollar for a twenty-cent tax deduction that I feel I must warn you against potential bad advice. When you have something in your life that grants you a tax deduction or credit that is a good thing. But many of the things that grant you deductions are bad, like interest on the debt. It makes no sense to keep the debt that you are paying interest on so you can deduct a fraction (dictated by your tax bracket) of that debt on your income taxes. Always get rid of debt as fast as you can; taxes are no reason to retain it.
The absolute best way to “hide” money from Uncle Sam is to make the maximum contribution to your 401(k) and IRA every year. Your tax advisor may remind you that you can contribute to your IRA into the next calendar year and still claim the deduction on the prior year’s taxes. The best thing to do is invest your money as soon as you get it. Waiting until the end of the year deprives you of a year’s interest, and a year can make a big difference in the grand scheme of your compounding retirement portfolio. However you contribute, all money up to a specified maximum comes out of your total income and you don’t have to pay any taxes on it. This can lower your tax liability, and it can also lower your tax bracket if you get lucky. Either way, it is a wonderful benefit that you should take full advantage of.