Income Taxes & Common Misconceptions
April 11, 2012
Matt Haab
Did you ever notice that when you put the words “The” and “IRS” together, it spells “THEIRS.” -author unknown
No one I know enjoys paying taxes. However, most of us dutifully pay our taxes — both to abide by our nation’s laws and out of respect for the nation we live in — despite what we may think about the current state of our tax system. It was Arthur Godrey who said, “I’m proud to pay taxes in the United States. The only thing is, I could be just as proud for half the money.”
When it comes to paying income taxes though, there are a couple common misconceptions that people tend to make. One is related to a question that I’m often asked. ”Should I give money to charity to reduce the amount of taxes I owe?” I’m all for giving money to charity, so don’t get me wrong. In fact, if you feel so charitably inclined today, check out Coburn Place, a local safe haven for women and their children who have suffered from domestic violence. Our firm has selected this organization as our primary charitable focus this year. We will work with them closely both in volunteering and fundraising. But back to my point on taxes, giving money to charities to avoid taxes is a poor wealth-building technique because for most of us, every dollar given to charity may save us 25 – 35 cents in taxes, but we lose the remaining value of that dollar given. So you are losing 65 – 75 cents on that dollar. Some people seem to think that by doing this, they’re creating wealth, but unfortunately, it’s quite the opposite. Hence, the misconception. Give to worthy charitable causes because you want to give to these organizations, not because you want to create the tax deduction. However, one great tax saving technique in charitable giving is to give highly appreciated stocks or mutual funds, as that is one of the rare items that qualifies for a “double tax deduction.” You receive a tax deduction at the fair market value and don’t have to recognize the capital gains that you normally would when you otherwise dispose of the investment.
Speaking of investments, that brings up another common misconception. We have heard at times from clients — especially those in higher tax brackets — that they don’t want to invest in higher yielding investments because of the income tax repercussions of that additional income. If the goal is to invest that money to build wealth, then that line of reasoning doesn’t add up. If your money is sitting in cash earning 0% these days, which it is (or close to it), you would rather earn as high an interest rate as possible on that money because any federal and state income taxes owed on that will be equivalent to 35% – 45% (sorry, California and New York residents!). That means that you are still retaining 55% – 65% of that higher interest income even after taxes are factored in. So you should always want to earn more on your money, assuming it is a prudent investment regardless of the income tax repercussions. Now you want to carefully examine what investments are held in your tax-advantaged and taxable investment accounts as you will typically want to keep your most tax-efficient investments in your taxable accounts when possible.
Bottom line: it is tax time — maybe not high on your list but don’t make a bad situation worse by falling into some common misconceptions people have about paying and/or avoiding income taxes.