Tax Misconceptions

tax related word mapI’ve said before that increasing your understanding of taxes is an important part of building wealth. And, as much as you might personally hate taxes, that’s the truth.

Wealthy individuals find their way to wealthy because they learn to make good decisions, and you’ll never make good tax decisions unless you put in the time and effort to educate yourself about them.

Despite the omnipresence of taxes in our lives, most of us are never given an education in them. Not in high school, and certainly not in college. In most cases, I’d be willing to bet you wouldn’t be able to file your own taxes.

If that describes you, don’t feel ashamed. You’re here to learn, and to do that you need to get rid of some common tax misconceptions.

Common Tax Misconceptions

I’ll be adding more topics in the future, but for now you can choose between the following:

  1. Why getting tax advice from your financial planner is a bad idea.
  2. Why going into a higher tax bracket doesn’t mean a huge increase to your tax bill.
  3. What’s the difference between a tax deduction and a tax credit?

If there’s a particular tax topic that you’d like addressed, please get in contact with me and I’ll do my best to find an answer for you. However, please keep in mind that I am not (yet) a CPA, and that in some cases the best thing for you to do is to talk with one of them directly.

Your financial planner is a tax expert

Before I get into this, let me say that I mean this generally, and not specifically. I’m confident that some financial planners and advisors are tax experts, but the reality is that most of them are not.

However, if you want, on average, a better chance of sitting down with a real tax expert, your best bet is going with a tax CPA.

Why?

First, the education requirements to become a CPA are, in most cases, higher than other professional certifications. For most states, CPAs are required to complete 150 credit hours before they’re eligible to obtain licensure.

You can be confident that while your financial planner might have a business, finance, or economics degree that required him or her to learn about investing, he or she has probably never had a class on tax. For an example, I did a quick survey of the four largest universities in my area and looked at their finance degrees.

None of them had a single class on taxation, even as an elective.

Contrast that to the accounting program for each of those universities. Every single one of them had at least one course on taxation.

In addition, if your state is one that requires 150 credit hours to receive a license, there’s a chance that your CPA has a master’s degree in accounting.

Most graduate level accounting programs offer a professional stem for CPAs going into auditing and a tax stem for CPAs who plan to work in tax. Between the four universities I looked at, the minimum number of classes focused exclusively on tax was 6.

On average, a CPA is going to have a much greater educational foundation in tax than a financial planner.

Second, most states require between a year or two years of work in public accounting before granting a CPA license to the candidate, meaning you can be confident that they’ve already spent time learning the ins and outs of tax.

Thirdly, for a tax CPA, they literally do nothing else.

Seriously.

Their job is to eat, sleep, and breath taxes. All of their professional time is devoted to the practice of learning about and dealing with the tax code for the benefit of their clients. If you’ve heard about it, they’ve probably seen it already, because you’re the hundredth person that’s come in with the exact same tax situation and they already know exactly what to do.

My point in all this is that you should probably take any tax advice coming from a financial planner with a huge grain of salt. If you choose to use a financial planner, talk to them about what he or she is good at, not what a CPA is good at.

Talk to a CPA about your taxes instead.

Going into a higher tax bracket means I’ll owe more in taxes

Sort of.

But not really.

This is a misconception that is, unfortunately, extremely widespread.

The basic understanding that most people have about the US tax brackets is that if you earn “too much” income, you’ll jump into the next highest tax bracket and that all of your income will be taxed at that higher rate.

As an example, let’s say that you’re married, filing jointly, and between you and your spouse, you earn $70,000 and are in the 15% tax bracket. Midway through the year, your spouse is offered a one-off opportunity to earn an extra $10,000 for doing two months’ worth of work on the side.

This tax misconception would have you say no to that opportunity because your new $80,000 income would push you into the 25% tax bracket (which starts at $75,900 in 2017) and end up costing you thousands of dollars in additional tax.

The logic is that you should avoid earning any additional income so that you don’t end up getting taxed at the higher rates.

The reality is, that’s not how the US tax system works at all.

The US tax code is a progressive tax system, where the more income you earn, the higher your tax rate, which most people understand, but they misunderstand the application of those tax rates.

The reality is that you are only taxed at your highest tax rate for the income you earn that falls in that tax bracket.

Let’s go back to our example for an illustration.

Most people think that having an $80,000 income and being in the 25% tax bracket means you’ll be taxed like this:

80,000 * .25 = $20,000 in taxes (without factoring in deductions, credits, and exclusions). Using this math, your after-tax income would be $60,000.

Compared to this:

70,000 * .15 = $10,500 in taxes, leaving you with an after-tax income of $59,500. Why work so much harder for an extra $500, after taxes?

Here’s how it actually works:

$80,000 is broken down by tax brackets. So, using the 2017 tax tables, you end up with this:

Your first $18,650 of income is taxed at 10%.

18,650 * .10 = $1,865 in taxes.

18,651 – 75,900 is taxed at 15%.

(75,900 – 18,650) = 57,250 * .15 = $8,587.50 in taxes.

75,901 – 80,000 is taxed at 25%.

(80,000 – 75,900) = 4,100 * .25 = $1,025 in taxes.

Add that all up, and you end up owing $11,477.50 in taxes, which is substantially less than the $20,000 most people think it is.

Your actual after-tax income would be $68,522.50, meaning that saying no to an extra $10,000 of income because you don’t want to be pushed into the next highest tax bracket was you giving up $9,022.50 in after-tax income.

$9,000 is a lot to pay for making a simple tax mistake.

Good thing you’ll never make it again.

Now, let me say again, this example does not factor in deductions, credits, and exclusions, which would complicate things and in some rare cases, change what decision would be best for you to make.

Which is why I recommend you talk with a CPA, because the tax code is a beast. Having said that, the general principle is the same.

Don’t avoid income so that you can avoid taxes.

A deduction is the same as a credit

If you haven’t had an education in taxes, I’m willing to bet you don’t know the difference between a tax credit and a tax deduction.

Because you might not know the difference, there’s a chance that you don’t see any reason to prefer one to the other, and might think of them as two ways of saying the same thing.

Before I had my first tax class, I certainly didn’t know the difference, and I had no idea why people made such a big fuss out of them in the first place.

Thankfully, this misconception is relatively easy to address, and a proper understanding of tax deductions and credits will help you to focus on activities that will maximize your after tax cashflows.

So first, what is a deduction, and what is a credit?

Well, not so fast. For that explanation to make sense, you first need to understand the term AGI.

AGI is an acronym for Adjusted Gross Income. Adjusted Gross Income is the amount of your income that you will be required to pay taxes on, without factoring deductions, credits, and exemptions into the mix. In a broad sense, any income you earn over the year will go into your calculation of AGI. A few exceptions to that general rule do exist, but I’m going to gloss over them for simplicity’s sake.

A tax deduction, on the other hand, reduces your taxable income by a certain amount. There are two types of tax deductions. One is known as a for AGI deduction, and the other is known as a from AGI deduction.

For AGI deductions are better than from AGI deductions because they reduce your AGI directly, which makes it easier for you to capture additional tax benefits that would be phased out or disallowed otherwise.

To give you an idea of what I mean, here’s a list of a few for AGI tax deductions:

  • Retirement contributions to qualified accounts (IRA, SIMPLE, SEP)
  • Alimony you paid
  • Moving expenses
  • Rental and royalty expenses
  • Business expenses (we’ll touch on this later)
  • Losses on the sale or disposition of assets used in a trade or business
  • Health insurance deduction (if self-employed)
  • One-half of self-employment taxes
  • Net capital losses (limited to $3,000 a year)
  • Student loan interest
  • Tuition and fees
  • Educator expenses

Just because you see an item here that you think applies to you, be careful when attempting to claim it on your taxes. These deductions are all subject to certain rules, so you shouldn’t go crazy with trying to deduct everything you possibly can.

Again, I recommend you speak with a CPA if you have additional questions.

Next, what are from AGI deductions?

From AGI deductions are tax deductions that congress allows you to take, but only after your AGI has been calculated. While from AGI deductions do reduce your taxable income, they are generally much more limited in scope and will provide you less benefit.

In general, from AGI deductions tend to be personal in nature, whereas for AGI deductions are usually related to a trade or business you might be involved in. Because congress cares less about subsiding your personal activities, they’ve made the rules governing how from AGI deductions work less favorable to you.

For example, several from AGI deductions are subject to phase-outs based on AGI, along with floors that require the deductible amount to be greater than that floor before they begin to take effect.

To illustrate, let’s assume that congress has created a rule that allows you to deduct money you spend on fly-fishing, but only if your AGI is below $110,000, and only if you spent more than 10% of your AGI on fly-fishing. If your AGI is $115,000, you’re out of luck and don’t get any deduction at all. If your AGI is $80,000, you qualify for the deduction, but only if you spent more than $8,000 on fly-fishing during the year. Those kinds of rules are why from AGI deductions are less favorable than for AGI deductions, which typically allow you to deduct the full amounts, with a few exceptions.

Also, please note that I made up the fly-fishing deduction. Don’t try to claim it when you file next year unless you want to explain to the IRS that you read about it on a blog.

When it comes to for AGI tax deductions, you’ll usually decide between itemizing your deductions and taking a standard deduction.

The standard deduction is a fixed amount and depends on your filing status. Generally, you’ll want to take the standard deduction unless your itemized deductions add up to more than the standard deduction after all required calculations.

Some commonly itemized from AGI tax deductions, which are all subject to additional rules:

  • Medical and dental expenses
  • Certain kinds of taxes paid
  • Interest expense
  • Gifts to charity
  • Casualty and theft losses
  • Job expenses

What are tax credits?

Alright, now that we’ve covered for AGI deductions and from AGI deductions, let’s move to tax credits.

Tax credits are like tax deductions in that they exist solely because of congressional grace (if you believe they have any). The difference is what tax credits affect. Instead of reducing your taxable income like deductions, tax credits directly reduce the taxes you owe, dollar for dollar, instead of a dollar times your tax rate like deductions. For that reason, they are much more preferential to you as a taxpayer.

Here’s how it works with a deduction:

If your taxable income is $10,000, you’re in the 10% tax bracket, and you receive a deduction of $1,000, your new taxable income is $9,000. That 9,000 is taxed at your marginal tax rate, so you owe taxes of 900, instead of the $1,000 you would have owed without the deduction. You can see the math below if it’s easier for you to look at it that way.

10,000 – 1,000 = 9,000 * .1 = $900 in tax

vs

10,000 * .1 = $1,000 in tax

Here’s how it works with a credit:

If your taxable income is $10,000, you’re in the 10% tax bracket, and you receive a credit of $1,000 your taxable income stays $10,000, but you owe $0 in taxes. Again, the math is below.

10,000 * .1 = 1,000 taxes pre-credit – 1,000 credit = $0 in tax

In almost every situation you should seek to maximize your credits in favor of maximizing your deductions. However, most of the time this will be difficult because congress restricts what credits are available to you. But, if you qualify for a credit or could qualify for a credit by making a slight change in your behavior, do it.

One last thing before we’re done.

Like for AGI deductions and from AGI deductions, credits are broken into two categories. The first category of tax credits is nonrefundable credits, and the second category is refundable credits.

Nonrefundable tax credits are tax credits that can reduce the taxes you owe to zero, but they will never create a tax refund for you. Refundable credits can reduce the taxes you owe to zero, and create a refund of any unused portion of the credit you’re eligible for.

Going back to our example from earlier, let’s say that your taxable income was $5,000 instead of $10,000, you’re still in the 10% tax bracket, and you are eligible for a $1,000 tax credit. If the credit is nonrefundable, you owe $0 in taxes but don’t get a refund. If the credit is refundable, you owe $0 in taxes and you’re eligible for a $500 refund, which represents the amount of the credit you didn’t use. See the math below.

5,000 * .1 = 500 – 1,000 = (500), so a $500 refund to you.

If you have additional questions about tax credits you think you qualify for, you can get in contact with me. However, if you have complex tax questions, I recommend you speak to a CPA.