The Eight Tax Rules (Free Money Finance)

The following is an excerpt from Securing Your Financial Future: Complete Personal Finance for Beginners courtesy of Rowman & Littlefield Publishers. All Rights Reserved.

Taxes! Strong opinions abound on virtually every aspect of the subject?at least among taxpayers. Are taxes already too high, or are even higher taxes necessary to balance the budget? Is the burden fairly distributed, or are adjustments in order? Is the tax code complicated in order to ensure fairness across a wide variety of situations, or is the complication simply the result of privileged interests getting what they want? If you think of those as contemporary questions, they?re really not?they have been brought up and debated for as long as there have been taxes.

If you are interested in pursuing those kinds of discussions, you?ll have no trouble finding forums to do so. But we?re not going to engage in any of that here. Instead we want to take a realistic look at the effect that taxes have on your financial life and offer some practical advice about how to deal with them successfully. In our discussion, we?ll focus solely on the U.S. federal income tax. Even though that?s not the only type of tax that you?ll pay, it is likely to be the biggest, and many of the points that we?ll discuss are adaptable across the tax landscape.

Since taxes are all about rules, that?s the format we?ll take. Below are eight rules that I recommend you follow in dealing with taxes. The first four are principles that you should adopt, and the next four are specific areas of competency that I recommend you develop.

1.? Pay your taxes in full, on time, every time. Taxes are serious business, and they deserve your complete attention. A rule like this might seem obvious, but I?m including it to emphasize that taking a casual, haphazard, or last-minute approach toward complying with tax laws is an extraordinarily bad idea. The consequences of ever getting on the wrong side of the IRS, or any other tax enforcement body, are significant.

2.? Pay the minimum legal amount of taxes that you owe and not a penny more. Understanding rule #2 requires that you understand the difference between two similar-sounding, but vastly different, words: evading taxes and avoiding taxes. Tax evasion is a criminal offense. It refers to dishonestly or fraudulently misrepresenting your financial status to reduce tax payments. On the other hand, tax avoidance is perfectly legal. This refers to taxpayers making decisions explicitly to take advantage of specific rules in the tax code, to reduce their tax liability. The tax code is complex. Two taxpayers with identical financial situations can end up paying wildly different amounts, both perfectly legally. The taxpayer who pays less has done so by being more familiar with which specific elements of the tax code could be legally used to his or her advantage and then doing so. Legally and financially speaking, there is no virtue at all in paying more taxes than you are required to. Do not evade taxes, but avoid them to the greatest extent that you legally can.

3.? Commit to understanding the basics of the income tax and to keeping your understanding current.? This rule is a natural extension of rule #2.? If you don?t have a good working knowledge of the basics, or at least the basics that are most applicable to your own situation, you are very likely to end up paying more tax than you need to. To state it a little more forcefully?ignorance of the tax code is likely to be an expensive habit. You don?t need to become an expert, and you don?t need to build your knowledge overnight. But you can commit to improving your knowledge of the important basics, year after year.

4.? Have an effective record-keeping process. There?s no way around it?a fundamental part of financial responsibility is keeping good financial records. If you?re already following the recommendations made in recent chapters?doing all your spending using either a debit or credit card featuring summarized, downloadable transaction details?then you?ve already got the most challenging part of this under control. Keep this, and all your other financial records, secure (and remotely backed up, if applicable), and your tax preparation process will be significantly simplified.

5.? Know your marginal tax rate (your tax bracket) and your average tax rate. You probably know that tax rates are structured in a graduated, or progressive, way. This means that higher and higher levels of income are taxed at higher and higher rates. At the time of this writing, there are six brackets of income, with six progressively higher tax percentages levied on each one. The lowest bracket is 10%, ranging up to the highest rate of 35%. (I?m emphasizing ?at the time of this writing? because the number of brackets, and the rates charged, can and do change from year to year. For example, the number of brackets has been as few as three and as many as fifteen. The U.S. Congress has proven very willing to adjust the structure in response to all kinds of economic and political forces and is likely to continue this practice.)

How do these progressive brackets work? Let?s say that you earn just barely enough to put you into the highest tax bracket: 35%. (Congratulations!) That doesn?t mean that your total tax bill is 35% of your income. Instead, you pay 10% on your first ?chunk? of income, a higher rate on the next chunk, and so on; you only pay 35% on the very last chunk. In this example, by the time you add all that up, your total tax bill would average out to about 29% of your total income. In tax language, we say that your marginal tax rate is 35%, but your average tax rate is 29%. Both rates are important. The average tax rate is important because it determines your total tax bill. The marginal rate is also important because that?s the rate you?ll pay on any additional income you earn this year. For example, if you are considering earning some supplemental income, understand that you?ll pay 35% on that extra income, not 29%.

6.? Have a deduction strategy. Deductions are expenses that the tax code allows you to subtract from your income before your tax is figured. Examples of deductible expenses are mortgage interest paid on an owner-occupied house, charitable donations, a certain portion of your medical expenses, and a long list of others. The more deductions you have (in dollars), the lower your total tax bill is. The tax code gives you a choice: you can list all your deductions one by one and add them up (this is called itemizing) or you can take a single flat amount that the government offers everyone called the standard deduction?one or the other, but not both. Which do you take? Whichever is higher, because that?s how you legally pay the least tax.

It is in your interest to know whether your deductible expenses in any given year are likely to be higher or lower than the standard deduction. Early in your financial life, before you own a house, it isn?t unusual simply to take the standard deduction. But eventually your deductible expenses will probably begin to approach the standard deduction amount, and sooner or later it will make more sense to itemize. You don?t want to miss that crossover point because each year you take the standard deduction when you could have itemized could cost you in unnecessary taxes.

7.? Have a withholding strategy. Like most U.S. employees past and present, I am a veteran of many coffee-break debates about what the ideal tax-withholding strategy is. What is a withholding strategy? As Bobby Budget explained to Billy Bigshot, employees fill out a form with their employer called a W-4. Based on how it is filled out, the employer knows how much to withhold from your earnings toward your income tax. When you eventually file your return, if the amount withheld is greater than your actual tax bill, you get a refund check from the U.S. government. If your tax bill is higher than what has been withheld, you pay the government the difference.

Contrary to what a lot of the coffee-break debaters believe, getting a big refund check year after year is not an indication of financial genius?just the opposite! When you get a big refund check, it just means that the IRS has been holding your money on your behalf; and while they are holding it, they are earning interest on that refund money?and you?re not! In other words, you?ve just generously provided the IRS with an interest-free loan. On the other hand, if your employer doesn?t withhold enough, you get to earn interest on that difference, until you have to pay. In both cases, the amount of tax paid is identical?the only difference is who is earning interest.

So what is the ideal withholding strategy? It depends on your skill level at budgeting and tax bill estimation. If you are a rookie at both, then you should be conservative and aim for a zero difference between your tax bill and the amount withheld (zero refund, zero additional tax owed). Once your skill level is high, though, you can get more aggressive at reducing your withholding and earning interest on the money that you will eventually have to pay in taxes. The extra skill is required because you will have to be completely certain that when your tax bill is due, you will have the funds available to pay your taxes. How do you adjust your withholding? Work with your employer?s payroll department, or any tax professional, who can advise you on perfectly legal ways to adjust your W-4 to your advantage.

8.? Know when to seek outside expertise, and what kind. Here is a simple model, listed in the order of increasing expense to you:

• Level 1: Do all taxes and tax research yourself, using readily available resources. You can buy or check out one or more books, search online, and so on.


• Level 2:? Use tax software, carefully researching which product best meets your needs and ensuring you only use the most up-to-date version. Often it is possible to use software that can also be used in automating your budgeting process.


• Level 3: Engage a certified tax professional. Services can range from simply filing your return based on information that you provide to extensive consultation on tax planning for the current and future years.

When you are just starting out in your financial life, level 1 may be perfectly sufficient. Or you may be someone who is so comfortable with computing tools that you couldn?t imagine filling out a tax form when you know there are simple applications available that can do the job better than you can; if that?s the case, you might skip directly to level 2. Eventually, though, your financial life may get complicated enough that you?ll want to go to level 3. Each level costs more than the preceding one; but each level also offers a greater chance of spotting potential tax savings. The more complex your situation becomes, the more likely it is that it makes sense to move to the next higher level.

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