Saturday, December 15, 2018

6 Tax Myths That Even Smart People Believe

While I am not a CPA nor do I have any special expertise in taxes, I have found that there is a lot of mis-information out there about how US Income Taxes work, even among people who you expect to know better.  Let's take a look at some:

You Need to Hire an Expert

Preparing a tax return can be tedious and there is nothing wrong with outsourcing the job, any more than there is anything wrong with paying someone to cut your grass.  However, both are chores that the overwhelming majority of Americans are perfectly capable of performing for themselves.  

Do you need an expert?  Assuming you are of at least average intelligence and can read and follow directions, the answer is probably "no".  However, these questions may help you decide if you are one who actually NEEDS to hire help:

  • Are you self-employed?  If so, (and I mean a real job, not making a couple of hundred dollars a year running a blog), it is very possible that you need a CPA to determine the income and expenses of your business, which then pours into your tax return.
  • Do you invest in ways that do not generate tax forms at the end of the year?  Are you buying and selling real estate, investing in the neighborhood restaurant or engaging in similar endeavors?  You are well aware that $100 in the cash drawer is not $100 income.  A CPA may be very helpful in determining what is.
  • Is your income all accounted for in year-end forms from your employer and/or brokerage house(s)?  If so, transferring that data to your 1040 is a data entry exercise.  If you want to pay someone to take that chore off your hands, that's fine, but it's a want, not a need.
  • If you add up your mortgage interest and your charitable contributions for the year, do they total more than $12,000 if you are single or more than $24,000 if you are married?  If yes, then it may be worthwhile for you to itemize your deductions, and a CPA or enrolled agent may be able to find you some more deductions that you might miss--or they might not.  If your mortgage interest and charitable deductions combined are far less than $12,000/$24,000, does your family have substantial medical bills?  You can only deduct medical bills that exceed 7.5% of your Adjusted Gross Income.  There are few people with normal finances for whom it is worthwhile to itemize that do not exceed the standard deduction with these three items.  If you are going to be taking the standard deduction, there is no calculation, tax knowledge or discretion involved. 
  • A person with relatively normal finances lives in a home that she or he rents or owns.  He or she goes to work at a job that reports his/her income on a W-2 or 1099.  He or she invests money via a workplace retirement plan or with a broker who sends out year-end forms.  The further away from normal you are, the more you should consider professional help.  The more normal you are, the more likely that an online or packaged software program will meet your needs. 
Most Americans are more than capable of filling out their own tax return, particularly if they use one of the commerically available packages.  

You Need to Be Careful to Not Earn Too Much or You'll End Up In a Higher Tax Bracket

US taxpayer fall into one of seven tax brackets.  They range from 10% to 37%.  However, that does not mean that US taxpayers pay 10% to 37% of their paychecks in income taxes.  It also does not mean that earning a little bit more money can cost you a LOT more in taxes. 

Once you compute your taxable income, the first $12,000/$24,000 is exempt from income taxes (standard deduction), unless you itemize, in which case more money (depending on the deductions) is exempt from taxes.  So, a married couple with  income of $100,000 would pay taxes on only $76,000.  

Next, the tax brackets refer to income bands. Singles pay a 10% tax on amounts up to $9,525; married couples pay 10% of amounts up to $19,050.  So, our couple with income of $100,000 will pay $1,905.00 in taxes on their first $43,050 in income.  The next bracket is 12% and it covers income from $19,051 to $77,400.  Since my couple's taxable income is $76,000, and we've already computed the taxes on the first $19,050, we need to compute the taxes on the rest ($76,000-$19,050=$56,950) at 12%.  So, 12% of $56,950=$6,834.00.  You then add that to the tax on the first amount taxed at 10% and get $8739.  

Some people believe that if a couple's income went from $19,050 to $19,100, their taxes would go from $1,905 (10% of $19,050)  to $2,292 (12% of $19,100) such that a $50 raise would cost them $387.00 in taxes.  That's just not true.  All married couples who file jointly pay 10% on the first $19,050.  They pay 12% on the amounts between $19,051 and $77,400.  

I Need More Tax Deductions

Under today's tax code the overwhelming majority of people are going to end up taking the standard deduction.  They don't need to save receipts from junk given to Goodwill.  They don't need to worry about how many miles they drove for Girl Scouts.  It just doesn't matter.  

Right now, if I borrowed $500,000 to buy a house at the rate Chase is offering in my state, my first year's interest would be $22,500, which would put me in the neighborhood of considering itemizing.  If your mortgage is substantially less than $500,000 then your mortgage interest is not likely to be enough to make itemizing worth it.  

When you fill out a huge form and it tells you that you found $xxx in deductions, it may make you feel good, but most deductions simply reduce the cost of things you bought.  Spending $10 on something you don't need in order to save $1.00 in taxes is dumb.

The big exception is one that you can take even if you don't itemize--your IRA deductions.  While some people are better off not taking the deduction and putting the money in a Roth IRA (there are a lot of online calculators that will tell you if you are one), the IRA deduction allows you to have your deduction and your money both.

H&R Block and Similar Places Are Tax Experts

For many Americans tax time means a trip to the neighborhood strip mall to visit H&R Block or a similar store.  If you want to pay them to do your data entry, that's fine, just like it is fine if you want to pay someone to cut your grass.  However, while the person who programmed the computer that those places use consulted tax experts, the person who will actually do your taxes is paid $10-15 per hour in most places.  They are not tax experts, they are data entry clerks.  

Going into those places means sitting down with someone who leads you through a pre-programmed interview and enters your answer.  At the end, a return is generated.  Knowledge of tax law and accounting is not required.

Unless I Hand Fill a Paper Return, I Have to Pay

Many people like E-filing.  If you are getting a refund,  you get it more quickly by e-filing than by submitting a paper return. The government likes it when  you efile--it is easier for the IRS to process your return.  

There are two electronic options available to people who do not want to pay anyone anything for tax preparation.  

Freefile allows those with incomes below $66,000 who access the services through the IRS website to prepare and file a return using a variety of commerical online services (like H&R Block) at no cost.  While the services are allowed to charge for state returns and are allowed to "up-sell" the basic return is free to prepare and to efile.  

If your income is more than $66,000 and your tax situation is simple and/or you are fine with reading and following IRS directions, the IRS offers free fillable forms on its website. The forms do the math, but there is no interview-style set-up.  

A Big Refund Is a Good Thing

Having a big check (or direct deposit) show up in your account feels good.  If you can't save money that is in your hands, then overwitholding may be one of the few ways you can save for a big "fun" purchase, but the only advantage to this method is that it does happen automatically. 

If you are getting a big refund it is because you are allowing the government to hold your money for you, and to not pay your interest.  If you have to have money taken out of your hands to keep you from spending it, set up an automatic withdrawal to a different bank account.  

Did you believe any of these tax myths?

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