Unfounded Tax Advice for the Clueless
Oct 9th, 2007 by Alex
It astounds me how many young people don’t have a clue when it comes to money and taxes. Fewer still know how both relate to being a homeowner. It feels like some people go out of their way to know as little about finance as humanly possible. I don’t know if its a generational thing or if its everyone in general. Our tax code may be obscenely and needlessly complicated, but that doesn’t mean we ought to stand by and get shafted. Taxes aren’t that difficult to figure out, there’s just layers upon layers of information to wade through. Recently I’ve attempted to educate some of my friends about some financial and tax issues. Not enough to be a tax adviser, but enough to whet their appetite to go and look into it further. I try to simplify a few bits and pieces at a time so that its easier to understand.
Disclaimer: While I’m relatively confident in the concepts about to be presented, I am not a CPA. I’ve simplified some of the concepts that would normally read like gibberish and would prevent people from reading further. Your mileage may vary. If anything I write strikes a chord, go do some research or consult a tax professional.
Tax Refunds
When you get a tax refund at the end of the year, do you celebrate? Most people seem to. You shouldn’t. It’s nice to get money in the mail or transferred electronically, but what if it was your money to begin with? With income tax refunds, it is your money. Does the government pay you interest on the taxes that you overpaid? No way!
If anything you should be irritated that you just gave the government an interest-free loan for the year. That’s money that could have been sitting in your savings account earning interest or been put to good use throughout the year on fun things, expenses, or anything else that you wanted to do with it.
Having a smaller refund means that more of your money was in your control for the duration of the year.
Mortgage Payments
When you buy a house, the mortgage payment is composed of principle and interest. That’s basic mortgage stuff. The first few years you own your home the vast majority of the mortgage payment will be going towards interest. Check out an amortization table and be prepared to be shocked. As depressing as that may be compared to your car loan or credit card debt, the interest you pay as part of your mortgage payment is tax deductible. This is a very good thing.
Deductions, deschmuctions, and why you should care.
We all contribute a portion of our income to pay for common services, the military (regardless of whether or not you agree with what’s going on “over there”), expensive toilet seats, hammers, etc. Now forget all the stuff the government chooses to spend your hard-earned dollars on for a moment, because it isn’t relative for the moment. Your taxes and deductions can be broken down into a simple arithmetic problem.
Simply put, you owe tax on your income. More specifically, the tax you owe is calculated based on your adjusted gross income (AGI). You can check out the Tax Table in the 1040 Instruction booklet (PDF) if you like. Now — ready for this? because this is the important part — deductions (including mortgage interest) reduce your AGI, effectively reducing the amount of tax you owe.
Getting more out of your paycheck
If you increase the number of exemptions on your W-2 form, less tax will be taken out of your paycheck every pay period. This leaves you more money to pay your bills and otherwise live. Before you bought a house, you ran the risk of underpayment and having to write a check at the end of the year (possibly with a penalty attached). But with a large mortgage interest deduction, you can probably afford to bump up your exemptions a bit without underpaying. You might even be able to afford more of a house than you previously thought. The IRS Withholding Calculator is a bit complicated, but can help you figure out how to set your withholding. When in doubt, consult an accountant or tax professional.
That’s the end of my sermon.
![[del.icio.us]](http://images.del.icio.us/static/img/delicious.small.gif){kind=small}
You sound like my friend. He works for the state pension system, so he’s always going off about how people our age need to save for retirement. I think your advice would be unsolicited rather than unfounded, since you do make good points based on fact. In terms of your preaching, I’d be the choir.
danielle: Unsolicited yes, but unfounded in that I don’t work in finance and shouldn’t be confused with someone who does. One of the problems with tax code is that there’s all sorts of exceptions and exceptions to exceptions, making it really easy to lead people the wrong way. In any case, it’s a small choir.
An additional wrinkle to retirement is where it’s going. 401k or 403b? It’s pre-tax, but once you cash in 30 years from now, it’s tax free. On the other hand, a Roth IRA is a tax-free deduction, but it’ll be taxed once you cash it in. Or, wait, is it the other way around? Whatever. Either way, you should be putting as much money as you can into those every year too.
ACW: Sorta.
Both 401k and 403b are funded with pre-tax dollars and usually your employer matches your contribution in some way. They both can lower your taxable income considerably, but you will owe tax on the gains when you cash out in your retirement years. Contribution limit is $15,500 for those under 50, $5000 more worth of catch-up contributions if you’re over.
A Roth IRA is funded with post-tax dollars. When you cash out, you owe nothing. Contribution limit is currently $4000 per year, less if you make more than $95,000 per year.
Recently some employers have been offering Roth 401k’s, funded with pre-tax dollars and matched to a point by employers and tax-free on payout. Sounds too good to be true, really. The contribution limits are a lot lower to compensate, I think.
My opinion: fund both.