Tax day is rapidly approaching. In less than two weeks Americans must file their income tax returns, or at least file for an extension, to avoid all sorts of onerous penalties. I continue to advocate for the Fair Tax, which would make April 15th just another day in Spring, but that is for another article.
Beyond just the work involved in preparing tax returns, and the ever-present threat of an audit that strikes fear in most people’s hearts, is the control over financial decisions that the income tax code has that should be of concern. Indeed, two individuals can make the exact same amount of money and pay radically different taxes depending on the way the money was earned and things that they do to reduce their tax liability. A person who is in the 15% tax bracket will pay $750 more in taxes than a person in the same bracket that puts $5000 in a standard IRA. A person who runs a hedge fund may pay taxes at 15 or 20% on his income while someone working as a professor may pay 25 or even 40% on hers, even at the same income level.
A great deal of time and money is spent in planning how one earns, saves, and spends money to reduce taxes. (Again, this is a great argument for enacting a Fair Tax instead. Why waste your time planning for taxes when you don’t need to?) This includes doing things like putting money into an HSA and then using the funds to pay medical bills rather than jus sending a check to a doctor since the former allows the expense to be deducted. Likewise, people put money for investment in IRAs and educational IRAs, 401k’s, SEPs, and other accounts to reduce taxes.
One major issue with tax regulations is that it tends to drive financial decisions for many people. For many years, IRA contributions were limited to $2000 per year per person. Many people would contribute only $2000 to an IRA because of this limitation without any thought to how much money would be needed in retirement. Likewise, educational IRAs are limited to $2000 per child per year currently, which would provide $36,000 if the maximum contribution were made each year of a child’s life up until college but no gains on the money were made. This might pay for tuition for a state college currently, but there would still be significant room and board costs, costs for books (or perhaps e-books), and transportation and incidental costs. College costs could easily be $100,000-$200,000 for a state school in 18 years, so saving should be about $5,000 per year if possible. Saving should be even greater for a private school.
People also make bad financial decisions when it comes to selling investments because of tax laws. The worst example of which I ever heard was during the dot-com bust of 2000 where a woman who was a paper millionaire in the stock of an internet start-up at which she worked. Her broker convinced her to take out a loan against the shares to buy a new house rather than selling shares of the stock she held since that would cause a big tax hit. The shares of the tech company in which she worked subsequently crashed, becoming worthless in a short period of time. In the end she ended up owing about $300,000 to her brokerage company!
This is an extreme case, but many investors don’t sell a stock that has appreciated considerably even though the company is unlikely to continue to see its stock increase further because doing so would cause a tax bill. Stocks can easily decline in price by 25% or more over short periods of time, which would cost significantly more than a 15% capital gains tax. There are also strategies – such as selling stocks in which a loss has been had – that can be used to reduce the tax liability when selling a big gainer.
Certainly it makes sense to invest in a style that minimizes taxes – which is long-term investing and the use of tax advantaged accounts like IRAs and Roth IRAs where possible – but taxes should not drive decisions unless the taxes are so significant so as to change to finances. For example, one wouldn’t not sell shares of Home Depot after a big run-up just because doing so would cause a capital gain, but one might not sell shares of Home Depot and shift to Lowe’s after a big run-up if the chance that the additional gain that could be had by investing in Lowe’s instead of Home Depot would not be enough to offset the tax liability.
So don’t let tax regulators make decisions about how much you should save for retirement or how much you need to save for your children’s education. Also consider taxes when choosing an investment style, but don’t let taxes dictate whether you sell a stock or not. Finally, don’t let your desire for avoiding taxes cause you to spend more money avoiding taxes than you would owe in taxes. For example, don’t keep holding a mortgage so that you can deduct the interest since you’ll be paying $10,000 per year in interest to avoid $1500 in taxes.
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Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.