Like many people I believed in several tax myths. Twenty years ago, my accountant helped me better understand some of the things I took for granted as true. I had started a contracting business a few years before.
Myth: Tax rate. I believed that, because I was in a 28% tax bracket, I paid 28% of my income in taxes.
“Too many people confuse their marginal tax rate, which is 28% in your case, with their effective tax rate,” my accountant said. We were reviewing my corporate and personal income tax returns. She pointed me to the Taxable Income line on my personal tax return.
“That’s your taxable income,” she said. Then she pointed me to the Tax line that followed. “That’s your tax. What is the percentage of the tax to your taxable income?” she asked.
“About 16%,” I replied.
“That’s your effective tax rate,” she said.
She continued, “I have other contractor clients who want to buy a new truck. They reason that, because they can deduct the purchase from their taxable income and they are in a similar tax bracket as you, the government is effectively paying for 30% of the cost of the truck. It sounds like a great deal to them and justifies the cost of a new truck. I ask them whether the first dollar they make or the last dollar they make will go to the new truck payment. This sounds puzzling at first. If the first dollar they make goes to the truck payment and that first dollar is taxed at only 10%, then the government is only picking up 10% of the cost for the new truck. Is the extra cost of a new truck justified if the government only picks up 10%? Do you see what my point is? You can’t say that you buy groceries and other necessities with the first dollar you make and then say you’ll buy the truck with the last dollar you make.” I nodded.
“The decision whether to buy a new truck,” she said, “should be based on a number of factors: additional work capability, reliability, less down time, savings from truck repairs, to name a few. Any tax savings is just one of those factors. It shouldn’t be the prime factor. Unless you pay cash for the truck, you’ll have interest charges that will add about 15% to the purchase price. At your effective tax rate, the government is simply picking up the interest you would pay on a truck loan.”
Myth: Capital Gains Tax. In the middle nineties, I wanted to sell some part of a mutual fund and put the money in a different mutual fund to diversify a little bit. I was a reasonably new and unsophisticated investor who had read that diversification was good. I had held off selling any shares in the fund for about a year because I didn’t want to pay the capital gains tax on the sale. Once again, my accountant gave me another tax lesson.
“Many people don’t realize that when they sell a mutual fund, they often pay little in capital gains tax or they may report a loss. For many funds, you have been paying the tax each year on any capital gains the fund has realized.”
That surprised me. She pointed me to a form in my tax return (Schedule D).
“Here’s the capital gains your fund had this year,” she said. That increased your taxable income and you paid tax on it. For many people, tax considerations should not be the prime reason they buy or sell a mutual fund, especially a stock fund. There are some bond funds and other less common investments which are not taxable and that’s a different story.”
Myth: Tax deferred accounts. In the mid nineties, I considered whether my company should set up a 401K retirement plan but the administrative costs and restrictions were impractical for a company my size.
“For employees the tax deferral feature and any matching employer contribution to a 401K plan are a big plus. For small companies with just a few employees, you lose the benefit of the employer contribution because you are the employer.”
“But what about the tax advantages?” I asked.
“Unlike many employees whose work hours are more or less fixed,” she replied, “you can offset the tax advantage of a 401K by working a few extra hours a week. In effect you are paying the taxes now so that you won’t have to pay them in the future. 30 years from now you won’t remember the extra hours you worked. You will have more control of your retirement funds. Who knows what Congress will decide to do with IRAs and 401Ks 30 years from now?”
“But,” I asked, “I’ll be in a lower tax bracket when I’m retired and I’ll pay less taxes on the money I take out of my IRA or 401K.”
“That’s true. But there is the matter of how a tax rate feels. When you are 75 years old and are on a fixed income, believe me, a 10% income tax rate feels like 20% or 30%. At a 10% tax rate, you have to take over $1100 out of your IRA or 401K to net $1000 to meet your expenses. At that age, you are very conscious of your dwindling savings. In your 30s, 40s and 50s, you can command more money for your labor than you can in your 60s, 70s and 80s. You can work a little extra now in order to buy peace of mind later and hopefully avoid having to get a part time job in your 70s to make ends meet.”