7 Tax Myths and How Al Capone Could Have Stayed Out of Jail

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Hey everybody!  I’ve been following some blogs, subreddits, and other news sources and wanted to give an explanation debunking the top tax myths I hear on almost a daily basis.  This advice is based on my understanding of the US Tax Code.  Although I am a CPA, I am by no means a tax expert and these items should not be taken as tax advice.

“Making more money will push me into a higher tax bracket!” (Also knows as my SO should stay home with the kids because his/her salary would just be eaten up by taxes).
This is a common misunderstanding of how our tax structure works.  If you are in a 30% tax bracket, that does not mean that all of your income is taxed at a rate 30%.  It means that the highest rate any of your income is taxed is 30%.  For a single person, it looks like this (2013 rates):

10% on taxable income from $0 to $8,925, plus
15% on taxable income over $8,925 to $36,250, plus
25% on taxable income over $36,250 to $87,850, plus
28% on taxable income over $87,850 to $183,250, plus
33% on taxable income over $183,250 to $398,350

Also, it’s important to note that taxable income is not the same as salary.  There are several ‘above the line’ deductions, such as student loan interest, standard deductions, personal exemptions that decrease the amount of your taxable income.

“Everyone should donate to charity because they can write it off on their taxes.”
Although there is an option to write off donations, it is only available to indivduals that itemize their deductions.  This means that you don’t take the standard deduction.  The standard deduction depends on your filing status (more on that later) and is as follows for 2013:

Single: $6,100
Head of Household: $8,950
Married Filing Joint: $12,200
Married Filing Separately: $6,100
Qualifying Widow/Widower: $12,200
Dependent: $1,000-$6,100

So, if you can’t itemize more than this amount (mortgage interest, health care expenses, tax prep fees, and donations are the biggest items) then it is in your advantage to claim the standard deduction.  This means that the old bed sheets and flannel shirts you gave to Goodwill just came out of the goodness of your heart.

“I am the HEAD of MY household, so that must be my filing status.”
This is a very advantageous filing status, so I understand why people want to make it apply for their situation.  For most people; however, this will not be the case.  Head of Household only applies to unmarried individuals that pay over half the cost of maintaining a home in which at least one qualified person lives for over half the year.  Basically, a single mother or father.  This can also apply to a person that cares for their dependent relative.  Otherwise, you’re stuck with us single folks.

“I should get married just for the tax break!”
If one spouse works and the other stays home, this may be the case (called a marriage bonus).  However, in the 21st century, with both spouses generally working, there is actually a marriage penalty.  This is due to the fact that rates, deductions, and phase out amounts are not a simple 2x calculation for a married couple (versus 2 single individuals).  For example, the 25% tax rate for single individuals stops at $87,850 adjusted gross income.  However, for married filing jointly, it stops at $146,400.  This results in $29,300 being taxed at the next bracket for a married couple.

“Fine, then I’ll just do married filing separately”
Nope.  This is the worst possible filing status.  Lower deductions/exemptions, higher tax rate brackets.  Pretty much the only reason to do this is if your husband/wife is making money Breaking Bad style and not claiming it on their tax return (also known as tax fraud, and it’s how Al Capone was thrown behind bars).

“Poor people don’t even pay taxes.”
No one pays taxes up to a certain amount each year (the standard deduction plus personal exemption).  For 2013, that amount (for a single filer) is $10,000 or (for a married filing jointly filer) is $20,000.  So, if you make under that amount, you wouldn’t pay any federal income taxes.  But seriously, if that’s what you are making, you need the money more than our Let’s-Threaten-To-Shutdown-The-Government-Every-Year friends in DC need it.  You may even get a refundable credit (meaning you get money back even if you didn’t pay anything).  However, you would still pay sales taxes, excise taxes, property taxes, fuel taxes, etc.  As mentioned in my I Pay How Much In Taxes Post, it is pretty much impossible for anyone to get away with paying NO taxes.

“I pay taxes on both sides of the road, so I should get to drive like a jackass.”
I can’t argue with this logic, but don’t be this guy.

What tax myths have you had to bust?  Anything you believe to be true that you’d like me to research?

Flickr Image Source: “Tax’ by 401(K) 2013

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Is ObamaCare an Obstacle to Financial Independence?

Hey everybody!  There’s been a lot of talk lately about the Affordable Care Act (ACA), more commonly referred to as ObamaCare.  Let me start by saying that I was in favor of health care reform and don’t want to use this as a forum for heated political discussions.  What I’d like to do is discuss the impact the law is going to have for my plan to financial independence (FI).  For those of you new to this blog, here is a quick summary of my FI goal:  I plan to save as much of my income as possible over the next 7-10 years with the goal of being able to “retire” early.  Once I feel comfortable money-wise (and if I want to at the time), I’d quit my day job to work on my passions (yoga, writing, teaching, etc).  This would mean giving up my employer’s health insurance plan.  With that said, here is a quick summary of how I understand the options once you leave your employer’s plan:

  1. You plan to live on less than 400% of the poverty level.  You qualify and will receive a subsidy correlated to how much you withdraw from your accounts and/or make on side hustles.  In order to get the subsidy, you have to go through the exchange to purchase the insurance.
  2. You plan to live on greater than 400% of the poverty level.  You will not qualify for a subsidy, meaning you have to pay 100% of the cost out of your pocket.  Now, you’ll want to do some research to find out what plan is best for you.  If you are relatively healthy, you may want to opt for a low premium (the amount you pay each month, regardless of if you need the insurance), high deductible (the total amount that you have to pay out of pocket before the insurance kicks in).  However, if you think that you may have some hefty medical bills in the future, you’ll likely want to choose a higher premium, lower deductible plan.  The choice is yours.
  3. You had private insurance prior to FI and are happy with your plan.  You may be able to keep your plan; however, that depends on if its coverage complies with ACA.  This is part of the hole that I see in the system.  Let me explain….

I’m going to use a 29-year-old male (let’s call him Bob) that doesn’t smoke as an example.

  • Pre-ACA: Bob can go to the private exchange and purchase a $10k annual-deductible plan for $42/month ($504/year).  Now, this means that any and all expenses up to $10k must be covered by Bob.  However, maybe Bob has easy access to $10k  and is willing to take the risk that he won’t actually need the insurance.  He doesn’t want to be stuck with the bill for expenses significantly above $10k, but he also wants to keep a low monthly rate.
  • ACA – private coverage: The cheapest option (according to ehealthinsurance.com) would be $189/month ($2,268/year).  Now, this is the “bronze” level plan, which covers quite a bit more than his old plan covered, which is nice, but he may not even need or want additional coverage.
  • ACA – public exchange: Here it is estimated at $211/month ($2,532/year) if he doesn’t qualify for a subsidy, based on the Subsidy Calculator.  This is what would change if you live on/make less than 400% of the poverty level.
  • ACA – catastrophic plans: Bob may be able to get a catastrophic plan, which is similar to the high deductible plans; however, he won’t qualify unless he has low-income (and under age 30) or a hardship exemption (and over age 30).  Which, I think we can all hope we don’t qualify for!
  • ACA – penalty tax: His last option is to weigh the costs of insurance against the penalty tax each year and go without insurance.  Let’s say it’s 2016 (ACA is fully implemented), Bob’s withdrawing $30k/year to live on and he has to pay the penalty of 2.5% of income.  He’ll have to pay $750 in penalty tax, which is $246 more than the original high-deductible plan.  So, now Bob pays more and gets no insurance.

What I believe this law is doing is raising the standard of health insurance in America to a level beyond what it needs to be.  And, in my opinion, this is an unfair application of the health care reform that we so desperately needed.  Individuals like Bob don’t need to be told what type of insurance they have.  For those of us that hope to be FI prior to Medicare age, we should be able to “self-insure” to a certain level.  I have heard about grandfathering certain plans in; however, I haven’t found anything very helpful to explain that concept, nor will it be relevant when I reach FI age.  Also, when you consider that 78% of the medical-related bankruptcies in the US happened to people that HAD MEDICAL INSURANCE, it shows that we most likely didn’t even fix the real problem (crazy-high medical costs) by requiring more people to have insurance.

Are you happy with how the law was implemented?  What would you change?  Do you plan on getting insurance if you don’t currently have it?  What do you think you’ll do when you reach FI?

Link love:  If you were looking for a better explanation of the details for complying with the law, check out this post by G.E. Miller at 20somethingfinance.

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Keeping Your Money Under Your Mattress Makes for a Bad Night’s Sleep

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Hey everybody!  Hopefully by now you understand how important savings is to achieving financial independence.  If you still need convincing, I’d recommend checking out the following posts:

Motley Fool - An Open Letter to Everyone Under Age 30
Mr. Money Moustache - The Shockingly Simple Math Behind Early Retirement
Get Rich Slowly – How Do I Start My Savings After Graduating College

However, a question I regularly see is “What am I supposed to do with the money I’ve saved?”  This is a valid point, as you don’t want to keep it under your mattress (fire, robbers, and poor back support are all reasons to avoid this Great-Depression-era technique).  So, here is my advice to newbie savers:

  1. Take advantage of your employer’s 401k plan.  This is the simplest way to invest since you fill out a form once and then it’s automatically taken out of each paycheck.  Even if your employer doesn’t offer a match, this type of plan has tax benefits that are important to a diversified portfolio.  If it does have a match, contribute at least as much necessary to take full advantage of the match.  Otherwise you are just leaving money on the table.  You can contribute up to the federal maximum level (2013 = $17,500); however, keep in mind that there are penalties for withdrawing early.
  2. Get a savings account.  I use Capital One (formerly ING) for my emergency savings.  This is the amount I think I may need in the event of a major life disrupting event (loss of employment, needing a new car, significant health issue, etc).  Personally, it helps me to keep this money separate from my day-to-day funds.  If you’re curious how to determine this amount, I recommend checking out a post by Jordann at Making Sense of Cents.
  3. Set up a Roth IRA.  Once you feel that you have enough emergency savings, I recommend getting a Roth IRA.  I suggest you check out  Vanguard, as they have the some of the lowest fees in the industry.  If possible, contribute the maximum allowed by federal law (2013 = $5,500).  Since these funds are after-tax, the government will even let you withdraw your contributions (but not the gains) in the event of a hardship.  Depending on your situation, it may even make sense to use this as an emergency fund, since you can only contribute so much each year.  The perk of this account is that you don’t have to pay tax on the gains!  Woo-hoo for free money!  Also, keep in mind that you can contribute through April 15 of the following year.
  4. Start personal investing.  Hopefully you will eventually come to the point where you need another outlet for all this money you are saving!  I have Lending Club and Scottrade accounts to fulfill these needs.  It requires as much research as you want it to.  Review stocks, follow blogs, watch the news….or just invest in an index fund (or specific loan type for Lending Club) and the work is done for you.

Personally, I’d recommend paying off debt before starting an aggressive savings plan (I recently paid off my student loans, and it felt AMAZING!).  However, it is important to do an analysis of each specific situation (considering interest rates, rates of return, benefits of the loan, such as deferment for some student loans) before making a decision what is a priority.

Also, note that I’m not adding Traditional IRA because I need to save for the years prior to 60, rather than have a ton more money tied up in funds that have penalties associated with early withdraw.  This option may be better for some people, specifically those who expect to be in a lower tax bracket during retirement.

What do you do with the money you save each month?  Are you saving for anything in particular?

Flickr Image Source: “Dollars” by 401(K) 2013

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