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Taxing Mistakes On Personal Finance Decisions



Managing your personal finances involves much more than simply investing money. It includes making all the pieces of your financial life fit together. And, managing your personal finances means developing a strategy to make the best use of your limited dollars and being prepared to deal with some adversity and changes to the landscape. Taxes are a large and vital piece of your financial puzzle. This post provides eleven taxing mistakes that you ought to know for savvy personal finance decisions, and six ways for comprehending bad taxation move in the case if you make it. By knowing the mistakes, you will have better chance to prevent them from happening. Enjoy!

The following list shows some of the ways that tax issues are involved in making sound financial decisions throughout the year:


  • Spending: The more you spend, the more taxes you’ll pay for taxed purchases and for being less able to take advantage of the many benefits in the tax code that require you to have money to invest in the first place. For example, contrary to the hucksters on late-night infomercials, you need money to purchase real estate, which offers many tax benefits. And because taxes are probably your largest or second biggest expenditure, a budget that overlooks tax-reduction strategies is likely doomed to fail. Unless you have wealthy, benevolent relatives, you may be stuck with a lifetime of working if you can’t save money.
  • Retirement accounts: Taking advantage of retirement accounts can mean tens, perhaps even hundreds of thousands more dollars in your pocket come retirement time.
  • Investing: Merely choosing investments that generate healthy rates of return isn’t enough. What matters is not what you make but what you keep — after paying taxes. Understand and capitalize on the many tax breaks available to investors in stocks, bonds, mutual funds, real estate, and your own business.
  • Protecting your assets: Some of your insurance decisions also affect the taxes you pay. You’d think that after a lifetime of tax payments, your heirs would be left alone when you pass on to the great beyond — wishful thinking. Estate planning can significantly reduce the taxes to be siphoned off from your estate.


Taxes infiltrate many areas of your personal finances. Some people make important financial decisions without considering taxes [and other important variables]. Conversely, in an obsession to minimize or avoid taxes, other people make decisions that are counterproductive to achieving their long-term personal and financial goals. Although this chapter shows you that taxes are an important component to factor into your major financial decisions, taxes should not drive or dictate the decisions you make.


Eleven Taxing Mistakes

Even if some parts of the tax system are hopelessly and unreasonably complicated, there’s no reason why you can’t learn from the mistakes of others to save yourself some money. With this goal in mind, this section details common tax blunders that people make when it comes to managing their money.


Mistake#1. Seeking Advice After A Major Decision

Too many people seek out information and hire help after making a decision, even though seeking preventive help ahead of time generally is wiser and less costly. Before making any major financial decisions, educate yourself. This book can help answer many of your questions. If you’re going to hire a tax advisor to give advice, do so before making your decision(s). The wrong move when selling a piece of real estate or taking money from a retirement account can cost you thousands of dollars in taxes!


Mistake#2. Failing To Withhold Enough Taxes

If you’re self-employed or earn significant taxable income from investments outside retirement accounts, you need to be making estimated quarterly tax payments. Likewise, if, during the year, you sell an investment at a profit, you may need to make a (higher) quarterly tax payment. Not having a human resources department to withhold taxes from their pay as they earn it, some self-employed people dig themselves into a perpetual tax hole by failing to submit estimated quarterly tax payments. They get behind in their tax payments during their first year of self employment and thereafter are always playing catch-up. Don’t be a “should’ve” victim. People often don’t discover that they “should’ve” paid more taxes during the year until after they complete their returns in the spring — or get penalty notices from the IRS and their states. Then they have to come up with sizable sums all at once.

To make quarterly tax payments, complete IRS Form 1040-ES, Estimated Tax for Individuals. This form and accompanying instructions explain how to calculate quarterly tax payments — the IRS even sends you payment coupons and envelopes in which to mail your checks.

Although we — and the IRS — want you to keep your taxes current during the year, we don’t want you to overpay. Some people have too much tax withheld during the year, and this overpayment can go on year after year. Although it may feel good to get a sizable refund check every spring, why should you loan your money to the government interest-free? When you work for an employer, you can complete a new W-4 to adjust your withholding. Turn the completed W-4 in to your employer. When you’re self-employed, complete Form 1040-ES.

If you know that you’d otherwise spend the extra tax money that you’re currently sending to the IRS, then this forced-savings strategy may have some value. But you can find other, better ways to make yourself save. You can set up all sorts of investments, such as mutual funds, to be funded by automatic contributions from your paychecks (or from a bank or investment account). Of course, if you happen to prefer to loan the IRS money — interest-free — go right ahead!


Mistake#3. Overlooking Legitimate Deductions

Some taxpayers miss out on perfectly legal tax deductions because they just don’t know about them. Ignorance is not bliss when it comes to your income taxes . . . it’s costly. If you aren’t going to take the time to discover the legitimate deductions available to you (you bought this book, so why not read the relevant parts of it?), spring for the cost of a competent tax advisor at least once.

Fearing an audit, some taxpayers (and even some tax preparers) avoid taking deductions that they have every right to take. Unless you have something to hide, such behavior is foolish and costly. Remember that a certain number of returns are randomly audited every year, so even when you don’t take every deduction to which you’re legally entitled, you may nevertheless get audited! And how bad is an audit, really? An hour or so with the IRS is not as bad as you might think. It may be worth the risk of claiming all the tax breaks to which you’re entitled, especially when you consider the amounts you can save through the years.


Mistake#4. Passing Up Retirement Accounts

All the tax deductions and tax deferrals that come with accounts such as 401(k)s, Keoghs, and IRAs were put in the tax code to encourage you to save for retirement. So why not take advantage of the benefits?

You probably have your reasons or excuses, but most excuses for missing out on this strategy just don’t make good financial sense. Most people underfund retirement accounts because they spend too much and because retirement seems so far away. Many people also mistakenly believe that retirement account money is totally inaccessible until they’re old enough to qualify for senior discounts. See Chapter 20 to find out all about retirement accounts and why you should fund them.


Mistake#5. Ignoring Tax Considerations When Investing

Suppose that you want to unload some stock so that you can buy a new car. You sell an investment at a significant profit and feel good about your financial genius. But, come tax time, you may feel differently.

Don’t forget to consider the taxes due on profits from the sale of investments (except those in retirement accounts) when making decisions about what you sell and when you sell it. Your tax situation also needs to factor in what you invest outside retirement accounts. When you’re in a relatively high tax bracket, you probably don’t want investments that pay much in taxable distributions such as taxable interest, which only add to your tax burden.


Mistake#6. Not Buying A Home

In the long run, owning a home should cost you less than renting. And because mortgage interest and property taxes are deductible, the government, in effect, subsidizes the cost of home ownership.

Even if the government didn’t help you with tax benefits when buying and owning a home, you’d still be better off owning over your adult life. If you instead rented, all your housing expenses are exposed to inflation, unless you have a great rent-controlled deal. So owning your own abode makes good financial and tax sense. And don’t let the lack of money for a down payment stand in your way — methods exist for buying real estate with little upfront money.

Mistake#7. Ignoring The Financial Aid Tax System

The college financial aid system in this country assumes that the money you save outside tax-sheltered retirement accounts is available to pay educational expenses. As a result, families who save money outside instead of inside retirement accounts may qualify for far less financial aid than they otherwise would. So in addition to normal income taxes, an extra financial aid “tax” is effectively exacted. Be sure to read Chapter 24, which covers the best ways to save and invest for educational costs.


Mistake#8. Neglecting The Timing Of Events You Can Control

The amount of tax you pay on certain transactions can vary, depending on the timing of events. If you’re nearing retirement, for example, you may soon be in a lower tax bracket. To the extent possible, you need to delay and avoid claiming investment income until your overall income level drops, and you need to take as many deductions or losses as you can now while your income still is high. Following are two tax-reducing strategies — income shifting and bunching or shifting deductions — that you may be able to put to good use when you can control the timing of either your income or deductions.


Mistake#9. Shifting Income

Suppose that your employer tells you in late December that you’re eligible for a bonus. You find out that you have the option of receiving your bonus in either December or January (ask your payroll and benefits department if this is an option). Looking ahead, if you’re pretty certain that you’re going to be in a higher tax bracket next year, request to receive your bonus in December.

Or suppose that you run your own business and operate on a cash accounting basis and think that you’ll be in a lower tax bracket next year. Perhaps business has slowed of late or you plan to take time off to be with a newborn or take an extended trip. You can send out some invoices later in the year so that your customers won’t pay you until January, which falls in the next tax year.


Mistake#10. Bunching Or Shifting Deductions

When the total of your itemized deductions on Schedule A (see Chapter 9) is lower than the standard deduction, you need to take the standard deduction. This itemized deduction total is worth checking each year, because you may have more deductions in some years than others, and you may occasionally be able to itemize.

When you can control the timing of payment of particular expenses that are eligible for itemizing, you can shift or bunch more of them into select years when you’re more likely to have enough deductions to take advantage of itemizing. Suppose that because you don’t have many itemized deductions this year, you use the standard deduction. Late in the year, however, you feel certain that you’ll itemize next year, because you plan to buy a home and will therefore be able to claim significant mortgage interest and property tax deductions.

It makes sense, then, to shift and bunch as many deductible expenses as possible into next year. For example, if you’re getting ready to make a tax-deductible donation of old clothes and household goods to charity, wait until January to do so.

In any tax year that you’re sure you won’t have enough deductions to be able to itemize, shift as many itemizable expenses as you can into the next tax year. Be careful when using your credit card to pay expenses. These expenses must be recognized for tax purposes in the year in which the charge was made on the card and not when you actually pay the credit card bill.


Mistake#11. Not Using Tax Advisors Effectively

If your financial situation is complicated, going it alone and relying only on the IRS booklets to figure your taxes usually is a mistake. Many people find the IRS instructions tedious and not geared toward highlighting opportunities for tax reductions. Instead, you can start by reading the relevant sections of this book. You can figure out taxes for yourself, or you can hire a tax advisor to figure them out for you. Doing nothing isn’t an advisable option!

When you’re overwhelmed by the complexity of particular financial decisions, get advice from tax and financial advisors who sell their time and nothing else. Protect yourself by checking references, clarifying what advice, analysis, and recommendations the advisor will provide for the fee charged. If your tax situation is complicated, you’ll probably more than recoup a preparer’s fee, as long as you take the time to hire a good advisor.

Remember that using a tax advisor is most beneficial when you face new tax questions or problems. If your tax situation remains complicated, or if you know that you’d do a worse job on your own, by all means keep using a tax preparer. But don’t pay a big fee year after year to a tax advisor who simply plugs your numbers into the tax forms. If your situation is unchanging or isn’t that complicated, consider hiring and paying someone to figure out your taxes one time. After that, go ahead and try completing your own tax return.


Five Ways for Comprehending the Causes of Bad Tax Decisions

When bad things happen, it’s usually for a variety of reasons. And so it is with making financial blunders that cause you to pay more tax dollars. The following sections describe some common culprits that may be keeping you from making tax-wise financial maneuvers and what you can do about them.


Way#1. Financial Planners And Broker’s Advice

Wanting to hire a financial advisor to help you make better financial decisions is a logical inclination, especially if you’re a time-starved person. But when you pick a poor planner or someone who isn’t a financial planner but rather a salesperson in disguise, watch out! Unfortunately, many people calling themselves financial planners, financial consultants, or financial advisors actually work on commission, which creates enormous conflicts of interest with providing unbiased and objective financial advice. Brokers and commission-based financial planners (who are also therefore brokers) structure their advice around selling you investment and other financial products that provide them with commissions. As a result, they tend to take a narrow view of your finances and frequently ignore the tax and other consequences of financial moves. Or they may pitch the supposed tax benefits of an investment they’re eager to sell you as a reason for you to buy it. It may provide a tax benefit for someone, but not necessarily for you in your specific situation.

The few planners who work on a fee basis primarily provide money-management services and charge 1 percent to 2 percent per year of the money they manage. Fee-based planners have their own conflicts of interest, because all things being equal, they want you to hire them to manage your money. Therefore, they can’t objectively help you decide whether you should pay off your mortgage and other debts, invest in real estate or a small business, or invest more in your employer’s retirement plan. In short, they have a bias against financial strategies that take your investment money out of their hands.

Be especially leery of planners, brokers, and money-managing planners who lobby you to sell investments that you’ve held for a while and that show a profit. If you sell these investments, you may have a hefty tax burden.

Way#2. Advertising

Another reason you may make tax missteps in managing your personal finances is advertising. Although reputable financial firms with terrific products advertise, the firms that spend the most on advertising often are the ones with inferior offerings. Being bombarded with ads whenever you listened to the radio, watched television, or read magazines and newspapers was bad enough, but now e-mail boxes are stuffed full of spam, and fax machines are blitzed with promos too.

Responding to ads usually is a bad financial move, regardless of whether the product being pitched is good, bad, or so-so, because the company placing the ad typically is trying to motivate you to buy a specific product. The company doesn’t care about your financial alternatives, whether its product fits with your tax situation, and so on. Many ads try to catch your attention with the supposed tax savings that their products generate.


Way#3. Advice From Publications

You read an article that recommends some investments. Tired of not taking charge and making financial decisions, you get on the phone, call an investment company, and — before you know it — you’ve invested. You feel a sense of relief and accomplishment you’ve done something.

Come tax time, you get all these confusing statements detailing dividends and capital gains that you must report on your tax return. Now you see that these investment strategies generate all sorts of taxable distributions that add to your tax burden. And you may be saddled with additional tax forms to complete by April 15. You wish you had known.

Articles in magazines, newspapers, newsletters, and on Web sites can help you stay informed, but they also can cause you to make ill-advised financial moves that overlook tax consequences. Article writers have limited space and often don’t consider the big picture or ways their advice can be misunderstood or misused. Even worse is that too many writers don’t know the tax consequences of what they’re writing about.


Way#4. Overspending

Far too many tax guides go on and on and on, talking about this tax break and that tax break. The problem is that to take advantage of many of the best tax breaks, you need to have money to invest. When you spend all that you earn, as most Americans do, you miss out on many terrific tax benefits that we tell you about in this book. And the more you spend, the more taxes you pay, both on your income and on the purchases you make (through sales taxes).

Just like losing weight, spending less sounds good, but most people have a hard time budgeting their finances and spending less than they earn. Perhaps you already know where the fat is in your spending. If you don’t, figuring out where all your monthly income is going is a real eye-opener. The task takes some detective work — looking through your credit card statements and your checkbook register to track your purchases and categorize your spending.


Way#5. Financial Illiteracy

Lack of education is at the root of most personal financial blunders. You may not understand the tax system and how to manage your finances, because you were never taught how to manage them in high school or college. Financial illiteracy is a widespread problem not just among the poor and undereducated. Most people don’t plan ahead and educate themselves with their financial goals in mind.

People react — or, worse, do nothing at all. You may dream, for example, about retiring and never having to work again. Or perhaps you hope that someday you can own a house or even a vacation home in the country or by the shore. You need to understand how to plan your finances so you can accomplish your financial goals. You also need to understand how the tax system works and how to navigate within it to work toward your objectives.

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