4 Tax-Related Personal Finance Myths
Posted by: Brookside Admin
The choices you make financially impact the amount of taxes you pay. That's a simple truth that most people understand. Or, at least they claim to understand it. In reality, many elements of personal finance that impact your taxes contain a number of misconceptions and myths. These misunderstood basics result in mistakes that cost you money. That may mean you're paying more taxes than you should be, or in some cases, you've missed opportunities in investing or earning additional money. Here are some of the most common personal finance myths that you should know the truth behind.
- Tax brackets and tax rates
Do you know how tax brackets and their accompanying tax rates really work? For individuals in 2016, the initial tax bracket covers anyone with an annual income of less than $9,275 and taxes that money at 10-percent. If you make between $9,275 and $37,650, the tax rate is 15-percent. That doesn't mean that your entire income is taxed an extra 5-percent if you make $9,276 instead of $9,274. If that were true, there would be many situations where making more money would actually cost you after taxes. However, that's not how these tax rates work. Instead, you pay the tax rate in each tax bracket below your total taxable income. For example, if you earned $30,000 in 2015, you'd pay 10-percent on $9,275 and 15-percent on the remaining $20,725. That results in $4036.25 in taxes owed, rather than $4,500. Those differences become more pronounced as income grows so it's important to understand exactly how you'll be taxed.
- Selling investments
Investing your money is typically a savvy choice, but there are taxes involved on any money you make. But, there's an important distinction in how money from a sold investment is taxed. Let's assume you invested in something simple like stocks. We'll use a 15-percent tax rate for that investment as an example. When your stocks go up and you decice to sell them, some people think you'll then pay a 15-percent tax on all of the money you've just gotten from the sale of your investment. So, if you initially invested $10,000, and your stocks increased value to $15,000, you'd owe $2,250. In this case, that's half of your profits, which makes investing much less attractive. But you won't be taxed on the lump sum of the money you receive. The initial $10,000 you invested isn't taxed. Only the $5,000 in gains is taxed at 15-percent in our example, which means you'd pay $750 in taxes instead of $2,250. Of course, these are simple examples and there are potentially other tax considerations to take into account with investments, but the main point to remember is that only gains are taxed when you sell investments.
One of the primary benefits of a 401(k) retirement account that's often trumpeted is that you don't have to pay taxes on the money you put into it. That's only partially true, however. You don't have to pay taxes on contributions to your 401(k) this year, but you will eventually. Let's use another example to illustrate this. If you made $40,000 in 2015, you'd pay the 25-percent tax rate on $2,350 of that. If you contributed to your 401(k), however, that money would be subtracted from your taxable income. Let's say you contributed $5,000 to your 401(k). That would make your taxable income only $35,000, which means none of your income is taxed at 25-percent and you save money. That $5,000 contribution and any other money you put into your 401(k) gets to accumulate without being taxed until you retire and begin withdrawing it. At that point, any money withdrawn from your 401(k) is added to other retirement benefits and taxed as a normal income. In some cases, depending on your income and the current tax rates, that could potentially mean your 401(k) contributions are taxed at a higher rate when you withdraw them than they would have been taxed when you earned them. That's a rare circumstance, however, and usually you'll save hundreds to thousands of dollars each year with 401(k) contributions.
- Big tax refunds
Most people want to get a large refund check from the IRS each year after they submit their tax return. Some even plan around getting that money each spring. In many cases, however, that big refund check costs you money. Remember that a refund is just that. The IRS isn't sending you free money. They're sending you money you've already paid them that ended up in excess of your final tax bill. For example, if you were to take $100 out of your paycheck each week, you'd end up paying $5,200 in taxes by the end of the year. After submitting your return and claiming deductions and write-offs, your tax bill only amounts to $2,200. That means you've paid $3,000 more than you needed to, which comes back as your refund. In this scenario, you don't seem to be losing money because you recoup any additional taxes you paid in during the year. But, consider if you'd only paid $50 per week in taxes. You'd have paid $2,600 in taxes for the year, and had an additional $400 per month. After submitting your tax return, you'd still get a small refund of $400. But the extra $400 you'd have at your disposal each month could be used to pay off debt from credit cards and loans to prevent it from compiling interest. It could also be deposited into a savings account, retirement account or investment portfolio. In each scenario, the money you saved throughout the year can be helping you save or earn more money, rather than letting the IRS hold it until they send you a refund check.
At Brown Kinion and Co. CPAs, we not only help you with your tax return, we take stock of your entire financial situation to help you find opportunities to save and earn more. Contact us to learn more about what a full-service CPA can do for you.