6 Common Tax Misunderstandings, Explained

During the first few months of the year, I read lots of articles and hear from many readers on the question of income taxes. It’s not surprising since filing income tax paperwork is part of the life of most American adults during these first few months of the year, and it’s always a painful process. No one enjoys seeing a large chunk of their income vanish out of their checking account, even if that money goes to a good cause.

This situation is made worse by people who share faulty and sometimes downright false information about income taxes, creating a picture that can mislead people and result in horrible mistakes and mistrust of the government based on bogus information. Here are six misunderstandings I see popping up all the time in emails, Facebook comments and messages, other blogs, and even sometimes in professional articles.

Misunderstanding #1 – It’s Legal for the Government to Collect Income Taxes, and You’re Not Being Clever By Avoiding Them or “Protesting” Them

I get a fair number of messages and emails from people urgently wanting me to address various financial theories and ideas that I regard as being fully in the domain of “crackpot.” One frequent topic of these messages concerns the idea that it is somehow “illegal” for the government to collect income taxes.

Such messages usually revolve around picking specific statutes out of the U.S. Code and arguing that those specific statutes demonstrate some level of fraud or show that income taxes don’t actually apply to individuals. Often, those statutes are taken completely out of context, where statutes written to cover a very specific issue are pulled and claimed to have much broader impact or apply to different groups outside of the scope of that law.

Often mixed into these arguments are documents that have no basis in the legal system of the United States, such as the holy books of various religions, unsourced books written by obscure authors, and other calls to authority that have little to do with the question of income taxes. Many of those documents are valuable, don’t get me wrong, but they don’t speak with any legal authority when it comes to income taxes.

So, what exactly is the legal basis for income taxes. First of all, the basic legality of taxes of all kinds is spelled out incredibly clearly in the Constitution. From Article 1, Section 8 of the Constitution: The Congress shall have power to lay and collect taxes, duties, imposts and excises, to pay the debts and provide for the common defense and general welfare of the United States; but all duties, imposts and excises shall be uniform throughout the United States Then, from Amendment 16 of the Constitution clarifies this, if it wasn’t clear already, and specifically applies it to incomes: The Congress shall have power to lay and collect taxes on incomes, from whatever source derived, without apportionment among the several states, and without regard to any census or enumeration.

Those are the foundational laws of our land. You can certainly dislike those laws and you can even work to overturn them by trying to get another amendment passed that overturns the sixteenth amendment, but those are the foundational laws of America.

The Internal Revenue Code is mostly a description of the specifics of the Sixteenth Amendment, explaining in detail how taxes are calculated and collected for various groups. It’s a very complex document, don’t get me wrong, and it’s full of lots of loopholes and strange clauses, and, yes, sometimes there are mistakes and problems in there that do need to be ironed out by the court system.

None of that means that the United States government has no legal basis with which to collect income taxes. They do, and wasting your time and energy objecting and “protesting” is going to do nothing more than create giant legal bills and headaches for you and it’s not going to get you out of paying taxes.

Misunderstanding #2 – Being in the 25% Tax Bracket Does Not Mean You Pay 25% of Your Income in Taxes

How income tax brackets work is often misunderstood and poorly explained. I’ve made my own attempts to explain it, too, but it’s a tricky enough concept, especially for people who have limited math backgrounds, that it can still be misunderstood.

In order to really iron it out, over the last few weeks, I’ve been working out an explanation of income tax brackets simply and clearly enough that my nine year old can understand how they work. The rest of this section is lifted and ever so slightly modified from that explanation.

Whenever you earn an income in the United States, you owe income taxes on that income which you have to pay to the government. The government then uses that money for things like building roads, keeping schools open, providing for our nation’s defense, and so on.

Ideally, the government wants a system so that people who don’t earn very much don’t have to pay very much in taxes, while people who earn a lot have to pay a bigger chunk of their income in taxes because, frankly, the rich can afford it more easily than the poor.

Part of the system they came up with was something called tax brackets. Here are the tax brackets for a single person in 2014:

You pay a 10% tax rate on income up to $9,075.
You pay a 15% tax rate on income between $9,076 and $36,900.
You pay a 25% tax rate on income between $36,901 and $89,350.
You pay a 28% tax rate on income between $89,351 and $186,350.
You pay a 33% tax rate on income between $186,351 and $405,100.
You pay a 35% tax rate on income between $405,101 and $406,750.
You pay a 39.6% tax rate on income between $406,751 and up.

So, let’s say a person makes $50,000 in taxable income in 2014. They earned more than that, to be sure – they’re able to deduct some things from the amount they owe, for example. Let’s say they earned $60,000 before taking all of those deductions. It’s easy to look at these tax brackets and think that this person will be paying a 25% income tax rate. After all, their income falls between $36,901 and $89,350. This person is considered to be in the 25% tax bracket.

However, 25% is not actually how much they pay in income taxes..

A person who makes $50,000 a year actually pays 10% taxes on their first $9,075 of income, then pays 15% taxes on their income between $9,076 and $36,900 (their next $27,825 in income), and then pays 25% taxes on their income between $36,901 and $50,000 (their remaining $13,100 in income).

So, on that first piece, they only owe $907.50 (10% of $9,075) plus $4,173.75 (15% of $27,825) plus $3,275 (25% of $13,100). That adds up to $8,356.25.

They actually only paid 16.7% in overall taxes ($8,356.25 divided by $50,000) on their taxable income, and only 13.9% in overall taxes ($8,356.25 divided by $60,000) on their total income before deductions.

That’s far below their tax bracket of 25%. Someone in the 25% tax bracket is not paying 25% of their income in income taxes – they’re paying far less.

This is a really important point for understanding the benefit of using a 401(k) for retirement savings. For simplicity’s sake, let’s say that the person above who made $60,000 this year had only one deduction – they put $10,000 of their income into a 401(k), which is a pre-tax contribution. Thus, as described earlier, they owe income taxes only on their remaining $50,000 in income.

If they had not done this, they would have actually had to pay income taxes on the full $60,000. That person would pay 10% taxes on their first $9,075 of income, then pay 15% taxes on their income between $9,076 and $36,900 (their next $27,825 in income), and then pay 25% taxes on their income between $36,901 and $60,000 (their remaining $23,100 in income).

So, on that first piece, they only owe $907.50 (10% of $9,075) plus $4,173.75 (15% of $27,825) plus $5,775 (25% of $23,100). That adds up to $10,856.25. Compare that to the taxes they would have paid if they had contributed $10,000 to their 401(k) – $8,356,25. The difference? $2,500 (which just happens to be 25% of $10,000 difference).

By not contributing to their retirement, that individual ends up paying $2,500 more in taxes this year. By contributing, that person was able to put $10,000 into the account and reduce their taxes by $2,500, so it only cost them $7,500 today to make that contribution. The government practically pays you to save for retirement.

Misunderstanding #3 – Deductions Don’t Have a Huge Impact on Your Taxes

People who write about taxes often make a huge deal about scoring more and more deductions in order to reduce your tax bill. Don’t get me wrong, deductions can save you money, but the amount that they save you is overblown.

Let’s use a fresh new example of a person who earns $60,000 a year, much like the person from the previous section. Let’s say that person pays $10,000 in mortgage interest and student loan interest in 2014. For that person earning $60,000 a year, a $10,000 deduction knocks that person’s tax bill down to $50,000, saving that person a total of $2,500 in taxes. That’s good, right?

Well, it’s not quite as awesome as it sounds. Each year, the federal government gives people a standard deduction. What that means is that they give you the option of deducting a certain amount from your taxes anyway without any proof that you had anything to actually deduct. The only way you can deduct more is if you can prove you had more deductions. (There are a few exceptions to this.)

So, let’s look at our example person. This person is a single person, so the government gives him or her a $6,200 standard deduction in 2014.

So, even if that person didn’t have any deductions at all, that person would still get a $6,200 deduction on their taxes. It would knock their taxable income down to $53,800 and give them a total tax bill of $9,306.25. With that mortgage interest and student loan interest, that person’s total tax bill is still $8,356.25. In truth, that person really only saved $950 on their taxes due to all of those interest payments versus just taking the standard deduction they would have taken anyway.

Income tax deductions are really only important if you’ve got a lot of them. People who tend to have a lot of deductions anyway are people who have a big mortgage or a lot of student loans. If that’s your situation, digging for more deductions actually can make a big difference.

Still, if you’re not finding thousands of dollars in deductions for things like student loan interest or mortgage interest or charitable contributions, you’re not going to likely reduce your tax bill at all by scrounging up a few more of them. The deduction chase just isn’t worth it unless you’ve already approaching five figures in deductions (when you’re single) or well into the five figures (if you’re married and filing jointly).

Save your receipts, sure, but don’t expect your deductions to make a gigantic difference on your taxes.

Misunderstanding #4 – You Need to Report All of Your Income, Even Cash and Even Income You Didn’t Receive Documents About

When people receive income in the form of cash, they often overlook it and fail to report it as income during tax season. This is also true if the person doesn’t receive a tax form at the end of the year describing their income – it’s often believed that this doesn’t have to be reported.

Sorry, that isn’t true, and if you skip it, you’re going to be in a real pickle if the IRS looks at you very closely.

Here’s the truth: any business owner worth their salt is going to keep track of the money they paid out because having good records of this is going to save them on their taxes at the end of the year. Even if they paid you in cash, it’s likely that they have some record of paying you and it’s also likely that they’re going to report this payment to the IRS. That means that the IRS is aware that you got paid and when you don’t report that payment, that puts up a red flag.

Even if you’re paid “under the table” for “odd jobs,” you still owe income taxes on that income. Yes, it’s likely very difficult for the IRS to track it, but if the person who paid you is keeping careful records, it can still show up to the IRS and get you in trouble later on.

What kind of trouble? Usually, situations like this are resolved with a fine and by paying interest on any missed tax payments. That can add up to quite a bit.

If you want to take a risk, you can always choose the route of filing taxes that don’t include some of your income on there. This strategy relies on the people who paid you having a poor record as well, and it does constitute breaking the law regardless of how well the other person records and reports things. If you get caught, you’ll owe the taxes, a penalty (most likely), and interest on the unpaid taxes.

The best route is to just follow the rules, report all income that you’re aware of (even if you don’t have paperwork for it), and pay anything that you owe. It’s far better than having a nasty surprise in a few years when you least expect it.

Misunderstanding #5 – There Are No “Tricks” to Avoid Audits – And Audits Are Rare and Rarely Disastrous

Pop culture has made many people afraid of income tax audits. The idea that the IRS will scrutinize your taxes, find thousands and thousands of dollars in mistakes from a few years back, and levy a giant bill against you that causes financial ruin is one that rests in the minds of a lot of people, fueled by a few exceptional cases of people who have tried to commit tax fraud and been caught.

The reality is that audits are pretty rare. Audits occur on about 1% of income taxes filed in a given year. Many of those audits occur because someone blatantly failed to report some significant source of income that the IRS discovered through other means. A few more are due to people claiming excessive amounts of deductions.

Even when an audit does occur, it’s usually a pretty straightforward event. My audit experience was handled entirely through the mail and involved me simply failing to report a small amount of income several years back, one that I didn’t receive a 1099 for at the end of the year. It wasn’t very stressful at all.

Also, even when an audit shows that you do owe some taxes, you can often negotiate if the amount is significant, particularly if the truth is realistic and indicates a reasonable mistake.

Audit horror stories often come from a very small segment of the public that is either trying to commit tax fraud or is committing a number of mistakes in filing their taxes.

When you read about “tricks” to avoid audits, they usually fall into one of two categories. Either they’re simple encouragements to actually report everything correctly and thoroughly so that there’s no reason to audit you or they’re in a legal grey area (at best) where you’re trying to cover up and hide income or false deductions. The first kind of advice is great, but it’s common sense; the second kind has a good chance of ending in disaster.

I simply encourage the first kind of advice. Report all of your income. Claim only deductions you can clearly document. Don’t bother with anything else. If you do that, you never have to fear an audit.

Misunderstanding #6 – A Big Refund Is Not (Necessarily) a Good Thing

One of my oldest friends claims zero allowances on his W4 in order to help himself receive a large tax refund. In his eyes, that tax refund check is a giant annual bonus that he can use for a vacation and other things.

In my eyes, a giant tax refund means that you loaned money to the government for a year without getting a dime in interest. I’d far rather keep that money for myself, keep it in a savings account or another investment, earn that return myself, and then actually pay a bit of income tax in April.

Here’s the truth: a tax refund means that throughout the year, you overpaid your taxes. You gave more money to the government than you needed to. A tax refund is simply the government giving back the taxes you overpaid.

Let’s say, instead, that you put in a correct number of allowances on your W4. What will happen is that your take-home pay will go up, but at the end of the year, your tax refund will go down. One way to look at it is that you’re getting your tax refund early, in small bits and pieces.

Many people use their tax refund check for a big purchase or a quick debt payoff. In truth, you could do the same thing by saving a small amount of your pay each week and then spending that amount in March or April instead of your tax refund. This way, it can sit in your savings account and actually earn a little interest, or you could use it earlier in the case of an emergency.

The problem is that many people don’t have the self-control to do that. If they have $20 extra in their paycheck, they’re tempted to spend it, so they use the IRS as a zero-interest savings account.

If you receive a big tax refund each year, I recommend opening up an online savings account at a place like Capital One 360. Set up an automatic transfer of, say, $10 or $20 a week from your checking account. Then, go to your workplace and alter your W4 to have the correct number of allowances.

What you’ll find if you do this is that you’ll still have your “refund,” but now it’s earning interest for you in a savings account and you can tap it whenever your needs are, not just when the IRS gets around to sending you a check in the spring.

Final Thoughts

Taxes are confusing and often financially painful. Because of that, many myths and false stories have sprung up around income taxes which make the situation far worse than it needs to be and can lead people down the road of making poor (and occasionally devastating) financial decisions.

Even if you don’t file taxes for yourself and don’t know much about the process, you should still take the information presented here to heart. There are many people out there spreading misinformation about taxes for their own ends, scaring you into making bad decisions. Don’t listen to the myths.

The post 6 Common Tax Misunderstandings, Explained appeared first on The Simple Dollar.