I came across a great article today that I felt compelled to write about. The piece, Life and Taxes, was written by Yaron Brook for Forbes. First, I would like each reader to stop for a moment and consider all of the impacts taxes have on your day-to-day life and on your financial decisions. The most obvious effect of taxation is the large chunk of income tax withholding that drains cash from each paycheck. Almost certainly you will recall the property tax, sales tax, FICA tax, gas tax, and sin taxes too. What Dr. Brook made me realize is that taxes actually have a much larger impact that just draining away your money.
Taxes are a means for the government to control the people. How is that possible you say? By rewarding the behaviors that the government deems moral and punishing the behaviors that the government deems immoral. There are carrots (ie rewards) for buying a home (mortgage interest deduction), saving for retirement (401(k) and IRA), having children (dependent and childcare deductions), and getting an education (Lifetime Learning Credit, Hope Credit, etc). There are also penalties, extra taxes, for driving a car with poor gas mileage (guzzler tax) and smoking and drinking (sin taxes). On the surface it appears that influencing or regulating these behaviors is indeed beneficial. Instead, I would agree with Dr. Brook that in fact this system is terrible for both the individual and society as a whole.
For example, how can it be bad to incentivize saving for retirement? The simple answer is because it distorts the free market mechanics of the economy. A better answer, and the one I focus on, is how it affects the individual. As a person intent on saving for my retirement I am going to save, invest, and prepare for the future no matter what. Now, because there is a government tax structure called a 401(k) it controls my behavior. Rather than select the investment brokerage I prefer, I am instead effectively handcuffed to a single provider. To get my tax break I am forced to pay a third party, which I did not select, management fees and commissions. Without this government intervention I'd be free to pick the lowest cost, best service provider and likely keep more of my money. The market place would respond to the increased freedom and choice given to the individual and in response companies would compete for my business.
Under the current system I am also limited in the investment vehicles available to me. Mutual funds, often with high costs, are the investment of choice in most 401(k) plans. The government and its retirement tax legislation discourages novel investment ideas and exotic asset classes. I am also restricted as to when, why, and how I access my own money. Again the government controls my behavior and my money by using the 401(k) legislation and the carrot of tax deductions. There is also a stick, to punish me, should I need to spend my own money before I reach the government designated age (59 1/2). Clearly early retirement is discouraged and the system is weighed against it. There is in fact, an illusion created by the system that everyone should work until the designated age. Why? It could be because it is good for the government but not necessarily for the individual.
Furthermore, not everyone has access to a 401(k) account. This skews the system of rewards further by punishing people who fit outside the accepted worker/drone role that the government overtly encourages. How many people would be more apt to take a different job, become an entrepreneur, or work as an independent consultant if the 401(k) system did not tip the scales. The same is even more true when we consider the tax incentive toward employer centered health insurance. Look at how much this government tinkering distorts our life choices! I am an employee less because that is what is best for me, but more because the government has created a tax system to pigeonhole me into that role.
There is even an entire legion of white collar professionals that exist solely to deal with the implications of the tax code and our governments policies of taxation. Accountants, tax preparers, IRA custodians, 401(k) plan providers, human resources benefits experts, and the entire IRS exist solely to execute this government moral agenda. If there was a vastly simplified tax legislation none of these people would be needed. In fact, most personal finance blogs too would have very little to talk about too if the government would butt out of our personal spending choices. No more headlines like: 46 Tax Deductions that Bloggers Often Overlook, My 401(k) to IRA Rollover Decision Process, or Bush Proposes Health Insurance Tax Reform. We could stop spending so much time reading blogs and analyzing the tax implications of our finances and simply make the best choice for us, as an individual.
There are dozens of other examples: buying too much house, having too many children, being content with underemployment, paying inflated tuition, being less productive (work less) because of punitive tax rates. These are all symptoms of tax policies which steer individuals to fall in line with the government determined ideal. The conceit that government can better decide than individuals is at the heart of this issue. Dr. Brook and I are in agreement that we are more than capable of making decisions for ourselves without any government meddling.
It could also simply be the unintended consequences and unfortunate side effects, but it all distorts the market none the less. The more I learn the more I wish government would stay out of my finances and let us use our freedom to make our own decisions about what is right for our money.
Thursday, April 24, 2008
Too Many Carrots?
Monday, February 18, 2008
Open Wallet: 2007 Taxes
I got down to business with our taxes yesterday afternoon. I have written before about how I was excited to do our taxes this year, especially because this will be the first year for us to itemize. I guess it really takes a personal finance geek to get excited about itemizing. I used the online program from Turbo Tax to make the process as painless as possible.
Right off the bat I got a bad surprise. Despite completing DW's W-4 to claim no exemptions, her employer still withheld no where near enough taxes. I had a feeling this was happening as I would look at the pay stubs, but I wasn't exactly motivated to decrease her take home pay. The Turbo Tax software I used keep a running tally of your results. I input my W-2 first and was greeted with a refund of several hundred dollars. Next I input DW's W-2 and saw us swing to owing $400. Bummer.
The next step was to start inputing the itemized deductions and credits. It cost me $29.95 to use the Deluxe version of Turbo Tax to get this done, but it was worth it to me for the sheer time savings. If your tax return will not require itemizing (meaning your deductions will be less than $10,300 for joint filers) you should use the FREE version.
The biggest of my deductions was the mortgage interest deduction. We bought a house back in May 2007 so we get to claim this credit for the first time. We also paid 1% of the loan in points and $243.21 on our share of property taxes. All of this pushed our real estate related deductions to $9,127.
The next deduction on the list was $167 for automobile registration for our two cars. After that I had to decide between deducting estimated sales tax or the $2,400 in state income taxes. I got a little lazy and just went with the income tax route. Our sales tax rate approaches 9% between state and local so that may have amounted to more, but it is also a pain in the rear to calculate. Finally, I claimed $400 in business expenses for 2007. This includes some use of my personal vehicle for non-commute work related driving.
The final positive to the bottom line was to claim the Hope Credit for my wife's 2008 tuition. I made sure to pay the bill in December 2007 so it could be claimed on our taxes ASAP. Her half time course load at community college was $665 for this current semester and it was 100% refundable. She will have one more year of Hope Credit left that will apply to 2008 so I look forward to that next year as well.
After deductions and credits we are owed a federal refund of $509.00. It is less than I had anticipated but any refund is better than none. The biggest effect on the bottom line came from my wife's too-low withholding and then a $665 education credit.
As for the state, I will be getting a $410 refund. I used the same data as the federal and Turbo Tax pulled it right over (for a fee of $30 of course) and eFiled for me. I'm not sure why but every year I have gotten a nice sizable state refund. Maybe I should increase the number of exemptions I claim. No sense in giving them an interest free loan every year.
Here is the breakdown:
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Friday, February 1, 2008
Is Social Security a Rip Off?
Today I came across a great article on The Dough Roller about Social Security. The post includes a great table that shows how much people at different incomes can expect to reap during retirement from everybody's favorite entitlement program. I have always resented the amount taken out of each check for social security, but today I learned something new. It really isn't all that bad for most people. The average person can expect to get $15,570 each year. This is is equivalent to buying an annuity which would cost $225,000. So at least you get something for all of the money that disappears from each check. Based on the present numbers it seems the social security isn't quite as big a rip off as I had thought. As it stands now, paying 6.2% of your gross earnings over your career gives a high earner 28% back every year for life.
I ran some of my own numbers assuming both no investment returns and an 8% return on contributions. An important thing to remember, which I originally forgot to include, is that your employer contributes an equal amount to Social Security in addition to the employee amount. My salary projections started at $97,500 (the Social Security ceiling for 2007) and, adjusted for inflation of 3% per year, topped out at $299,000 by 2045. I will pay $437k into social security before I hit retirement at age 62 (and my employer will match that amount). Assuming an 8% return that money would compound to $4.37 million dollars. That is equal to $1.42 million today. Wow! How does that compare to what Social Security actually pays out?
If I get 28% of my final salary in social security payments it would be approximately $83,000 per year. An equivalent annuity, would pay $83 per year for life starting at retirement and would cost $2.09 million dollars. In other words, I loose about half of the [$4.37 million] compounded contributions . Social security also includes disability and life insurance benefits, however these amount for only a tiny fraction of the $2,280,000 that disappeared.
The actual annual rate of return on contributions made to social security is around 4.75%. This is slightly below the historical average for government bond yields. If you factor in the tax deduction (SS taxes are deducted from gross income), assuming the 25% bracket, the return moves to a slightly more respectable 6%. This rate does indeed beat government bonds by a small margin so I'd consider it to be only a moderate rip off.
I am still young (24 years old) so I fully expect social security to change A LOT from now until I retire. Current projections indicate that there will be a shortfall of funding for the program of about a quarter of promised benefits starting in 2041 (4 years before I plan to retire). A 25% reduction in benefits seems almost certain but the cut may be even more by the time I retire.
If benefits are cut 25% and I only get 21% of my final salary I could take home $63,000 each year in retirement. Even in the best case, with a 25% tax deduction included, it would add up to a mere 4.7% annual return. That is a pretty sad return when you consider government bonds have averaged ~5.75% since World War II. If benefits get rolled back and no change is made to the payroll tax rates, it will dramatically reduce the value of Social Security to the middle and upper middle class.
Creating private accounts is one solution which could allow for returns of better than 4.7%. It may be a free market solution to the poor performance of Social Security. I would suggest taking a fixed percentage from all employees paycheck (tax free) and placing it into a fund similar to the government employees Thrift Savings Plan. It would offer a limited selection of broadly diversified index funds in which retirement money would be invested. The additional risk will need to be counter-balanced with a true insurance program that protects against market failures. This system would then replace our our current fixed check-a-month system of entitlement.
For now, Social Security is not as big a rip off as I had thought, even for those at the top end of the earning scale like I am. However, the 25% reduction in benefits would hurt the fairness of the program a great deal and drop rates to an intolerable level. We need to recognize now how unfair it would be to our workers to force them to earn below market returns on their contributions because we do not have the political will to make the needed changes. A free market return on all of their retirement investments, including Social Security, is the only fair way to fund retirement.
Tuesday, January 29, 2008
I <3 Taxes (Especially Refunds!)
I am actually really looking forward to doing my taxes this year. I've gotten a little more excited with every tax document that has arrived in the mail. Part of the excitement is knowing I will get a decent sized refund, but that is only part of my gaiety. This is the first year I will be itemizing my deductions! I must be a weirdo but I've been looking forward to this for a while. I now feel like my efforts to reduce my tax bill actually count. In years past, no matter what I small donations I tracked or small business losses I incurred, it never affected my bottom line. Last year my itemized deductions added up to around $6,000 so naturally I took the standard deduction for joint filers of $10,000 instead. This year we bought our first house so I have interest and origination points to deduct and education expenses for my wife's college classes. In all I should have around $1,000 to juice up my emergency fund.
I have a couple of 1099s, three W-2s, a 1098, and even a 1098-T. Each form arriving in the mail has been like getting a small piece of a birthday present I can't wait to unwrap. Sadly I am missing one W-2 from my wife's former employer or I would have already filed. Then the wait will begin for the great day when the IRS makes me whole again. Next year I may adjust my withholding so I won't be getting so much of a refund, but it would ruin most of the fun of tax season! In all seriousness if my refund does creep much over the $1,000 mark I will update my W-4s and keep more of each paycheck. I'm sure I could find the same enjoyment watching my savings balance grow each month instead.
Yesterday evening Don't Mess with Taxes posted the Tax Carnival #29: State of the Tax Union. I tuned into the State of the Union last night, and I must say that the blog posts from the carnival have a lot more useful information to share than any speeches given last night. Aspire 2 Wealth's contribution to the carnival was my post $1,200 Out of Thin Air about the proposed economic stimulus package the President rallied behind last night. Check out the article to get my take on the issue.
Friday, January 25, 2008
Millionaire Rule #7
Fund 401(k) to Get the Full Match
There is no better way to save for your financial future than to take advantage of a 401(k) which is matched by an employer. It is rare that I will state anything in the personal finance domain with this much certainty. An employer match is free money. No offense intended, but you would have to be an idiot to ignore FREE MONEY!
For those of you who have never heard of a 401(k) or don't really understand them I will give a quick primer. It is named after the section of the tax code which defines the rules of these accounts. A 401(k) is a savings account for the purpose of funding retirement. If you take money out before age 59 1/2 you will owe taxes and a 10% penalty to the IRS (DO NOT DO THIS). Money contributed is completely protected from taxes until you withdraw it. This tax benefit means that you can avoid taxes now. By avoiding taxes you will have more money to save, and each year your savings will continue to grow tax free until retirement.
A 401(k) account is set up by your employer, held at an independent financial services firm, and managed by YOU the investor. You choose how much goes into the account each pay check (call your HR department to set this up) and you pick your investments from a list of choices provided by the servicing firm. Lastly, and most importantly, many employers encourage employees to save by contributing money on the employee's behalf. This is called "matching" because it is normally arranged such that the employer will kick in a certain percentage of what the employee contributes. Common matching arrangements are 50% of every dollar up to a maximum of 3%; in this case an employee would contribute 6% of their gross pay and the employer would add an additional 3% (for a total of 9% of gross pay saved). Some employers are very generous and offer even more free money!
I will give a simple example to show the power of a 401(k). Lets consider Joe, a regular guy making $50,000 a year. Each year he will get a small raise of 3% and his investments return a moderate 8% per year. He is 30 years old and will work until he is 67 year old. The table below shows Joe's results depending on the type of investment account he uses.
I will say again, that not putting in the money necessary to get the full match is leaving free money on the table; don't do it. The best case shown in the table produced a nest egg of over $1.28 million which is roughly double what could have been saved in a taxable retirement account.
Now I realize that not every person has been lucky enough to find a job that offers a 401(k) and that a match is not offered in all 401(k) plans either. Do not loose hope! There are still other retirement saving options that are pretty good. If you want more information on your choices, continue reading the rest of my series Millionaire Rules.
Friday, December 14, 2007
Free Money with Tax Credits
The end of the 2007 tax year is almost upon us. Now is the time to take advantage of a few often overlooked tax credits to put some extra cash in your pocket. The most important thing to note is that a credit is different than a deduction in that the a credit directly reduces the tax which is owed while a deduction reduces the amount of income which is subject to taxes. For example, a Child Tax Credit of $1,000 directly reduces the tax due by $1,000 where as a $1,000 tax deduction would only be $1,000 * tax rate (generally from 10%-35%).
My List of [Little Known] Tax Credits:
- Adoption Tax Credit
- Child and Dependent Care Tax Credit
- Child Tax Credit
- Earned Income Tax Credit
- Foreign Tax Credit
- Credit for the Elderly and Disabled
- Hope Tax Credit
- Lifetime Learning Tax Credit
- Mortgage Interest Tax Credit
The Adoption Tax Credit is used to offset to the costs associated with the adoption of a child under the age of 18 or a person who is physical or mentally unable to care for themselves. This tax credit can be used for the reasonable and necessary fees, legal expenses, and other expenses directly related to the adoption. The credit can only be claimed in the year that an adoption is finalized (and only if the adoption is finalized). The credit amount is up to $10,960. In addition to the credit, and exemption of $10,960 for employer provided adoption assistance is also available. It is important to note that the same expenses can not be claimed for both the credit and employer assistance exemption. For further information refer to IRS Publication 968.
The Child and Dependent Care Tax Credit applies to the money spent to pay for care of a child or disabled dependent or spouse in order for the guardian to work or look for work. In order to be eligible the person paid to provide childcare can not be another dependent or a family member. The amount of expenses which can be claimed is up to $3,000 for one dependent or up to $6,000 for more than one dependent. The amount of the final credit decreases from 35% to 20% of claimed expenses as the adjusted gross income (AGI) of the filer increases from $15,000 to $43,000. For all AGI over $43,000 with $6,000 of claimed child care expenses the total credit amount would be $1,200. For further information refer to IRS Publication 503.
The Child Tax Credit is a fixed credit for each dependent child. The amount of the credit is $1,000 and decreases by $50 for each $1,000 of income over $110,000 for joint filers, $75,000 for single or head of household filers, and $55,000 for married filing separate returns. For a family of four with a AGI of $120,000 the total credit would be $1,500; $2,000 credit reduced by ($120,000 - $110,000)/$1,000 * 50, which is $500. For further information refer to IRS Publication 972.
The Earned Income Credit is a special tax credit for low income workers. The earned income credit is able to be refunded so in some circumstances even if a worker has no tax liability a refund may be due. The credit can be claimed by filers with children if their income is less than $34,001 if you have one dependent and $38,384 if you have two or more dependents. The credit can be claimed by filers without children if their income is less than $14,120 and the filer is between the ages of 25 and 65. You are not eligible for the earned income credit if you have non-qualified (interest, dividends, and other non-work related income) of more than $2,800. For further information refer to IRS Publication 596.
The Foreign Tax Credit is a reimbursement for foreign taxes paid to prevent double taxation of income from a foreign source which is subject to taxation by the United States and a foreign country. To claim the credit you must itemize you deductions and complete Form 1116 to calculate the amount of the credit. The credit is the lesser of the foreign tax paid or the equivalent amount of tax which would be paid if it were domestic income. Some restrictions and exemptions apply so be sure to carefully understand the eligibility rules. For more information refer to IRS Publication 514.
The Credit for the Elderly and Disabled is a credit for low income persons over the age of 65 and those identified as permanently disabled. The credit is 15% of the base amount. The base amount for each type of filer differs but the general amount of the credit is between $750 and $1125. To be eligible for the credit the AGI for single filers must be less than $17,500, for joint filers where only one spouse is eligible less than $20,000, for joint filers where both spouses are eligible less than $25,000, and for married persons filing separately $12,500. For more information refer to IRS Publication 603.
The Home Tax Credit is a reimbursement for the expenses incurred during the first two years spent pursuing a college degree. Qualified education expenses for the taxpayer, a spouse, or dependent can be claimed. A filer is eligible if their AGI is less than $55,000 for a single filer or $110,000 for joint filers. The amount of the credit decreases for AGI greater than $45,000 for single filers or $90,000 for joint filers. The amount of the credit is 100% of the first $1,100 in qualified expenses and 50% of the second $1,100. The total amount of the credit is $1,650 and it can be claimed only two years for any recipient. For more information refer to IRS Publication 970.
The Lifetime Learning Credit reimburses a tax filer for the expense incurred for education and job skill training for them self, a spouse, or a dependent. The credit is 20% of the claimed expenses up to $10,000 per year for a total credit of $2,000 per person per year. The credit phases out as AGI increases from $90,000 to $110,000 for joint filers or $45,000 to $55,000 for single filers. For more information refer to IRS Publication 970.
The Mortgage Interest Tax Credit is a special credit which can be claimed if a local or state government issued the taxpayer a mortgage interest tax certificate. A certificate is required to claim this tax credit. The amount is based on the amount of mortgage interest paid multiplied by the amount of the certificate. For more information refer to IRS Publication 936.
These tax credits can drastically reduce the amount of tax that is owed to the IRS. Make sure you consider each one when you prepare your taxes this year.
