Did the title scare you? If you don’t want to risk learning something, navigate away, ASAP. Although you might know these two things but people make the mistake all the time.
1. Tax write off versus tax credit: The way that federal income tax is configured it basically simple. You have to calculate your income and then based on that you have to pay a particular percentage. So if you make $100, and your marginal rate of tax is 20%, you pay $20 to the government.
But of course, it gets more complicated. There are many things that are included (and excluded) from your income that require some expertise. When you get a tax write off (deduction), this just means, for the purposes of calculating your tax, this will not count as income. This includes business expenses such as gas or mortgage payments. Thus in the above example, if you have a tax deduction of $50 for certain expenses, (and assuming your marginal rate doesn’t change), you will have been paid $100 that year, but you’re only taxed on $50, or a $10 tax.
Related to this, if you make below the minimum (currently around $5,000), it is not that you don’t pay tax. Instead, the government allows individuals to deduct that amount from their income, so now you have zero income, and no tax.
A tax credit, on the other hand, is subtracted AFTER your tax is calculated. So if you have a tax credit (very rare, but one more common example is child-care credits), this is subtracted from your tax liability, not your income. So if you made $100, you’d owe $20 in tax (from above), but with a $10 tax credit, you only have to pay $10.
Why does this mumbo jumbo matter? When people say “I get a tax write-off for doing this, so I should” that’s kind of silly. If it’s investment or something, that’s one thing. But if you buy a fancy car or something (again, I am heavily generalizing) that doesn’t make you any better off financially because your taxable income is lower just because you spent your money. Your take home is still reduced when you make these purchases, it isn’t, as I’ve heard people suggest, like the government pays you to make that investment. If you get a tax credit, that is better because you’re tax liability will be lower.
2. Tax Shelters: There is a poster up on the wall at school right now for a presentation with the title, “war on tax shelters?” A tax shelter is basically a way to structure a business transaction or investment so that you’re taxed very little or none. Tax shelters are not things that we should be violently protecting. (I understand there are some times we might want to with small business, with the savings and loan crisis, or maybe if you believe in trickle down economics, but read on).
Tax shelters are the tool of someone that is very business sophisticated. Average Janes don’t know how to structure their finances from taxation. The result then is that tax shelters allow the savvy to transfer the tax burden to someone else. Other people that are dutifully paying their portion of money they owe as an American citizen while those with tax shelters are finding rabbit holes out. The war on tax shelters is an effort to equalize the playing field so that everyone pays their taxes fairly. This is also an argument why you shouldn’t cheat on your taxes because that just means that you’re stealing from every other taxpayer.
Feel free to disagree with something in here or ask some (basically simple) questions about federal income tax that I could answer for you if you want. Also, my uncle reads my blog and he always does our family taxes so I bet he could answer even better for you.
15 responses so far ↓
1 DAD // Mar 19, 2007 at 5:35 pm
People cheat and steal from others all the time, I can be pretty assured that they have no problem stealing from the government especially when they feel the government owes them everything.
2 HB // Mar 19, 2007 at 6:02 pm
It’s not stealing from the government, it’s stealing from other taxpayers.
But yeah a lot of people think the world/government/everybody owes them things.
3 Mr. McBastard // Mar 19, 2007 at 9:07 pm
Not paying taxes isn’t really stealing from other tax-paying citizens. It’s not really stealing from anyone, because our taxes don’t go toward funding our government. They go toward the paying back the Federal Reserve what the US Government owes it — actually, probably mostly the interest; I doubt that our taxes pay for much of the principle. And no matter how much the US Government pays back to the Federal Reserve, they are still allowed to borrow any amount from the Fed. I’ve never heard of the US being denied a loan.
I’m not saying that it’s good to not pay taxes. I think if one person has to, everyone should. I’m just saying that it’s not necessarily stealing.
4 Harms // Mar 20, 2007 at 9:52 pm
Wasn’t the AMT designed to specifically combat the problem of tax shelters?
5 Miss HB // Mar 20, 2007 at 9:53 pm
AMT = ?
6 Anna // Mar 20, 2007 at 10:43 pm
If you’re right on the cusp between tax brackets, though - a little investment, although you would be spending it out of pocket, might end up with more in your pocket. Like if you’re making 80 dollars taxed at 50 percent : 40 dollars in tax, but if you are in the 70 dollar tax bracket, you would only be taxed at 40 percent = 28 dollars. If you donate/buy a car/etc with those 10 dollars to jump down a tax bracket, you’d be saving 2 bucks, net - even considering the money you “threw away” or what have you. So, I think, for the average person who is comfortably in the middle of a tax bracket, your number 1 would be true - - - but if you know ahead of time you’re on the edge - go ahead and donate (or whatever you want to get your tax write off) the 10 bucks and get a bit of a tax break.
7 misshb // Mar 20, 2007 at 11:03 pm
Very good analysis Anna
That was too detailed for my first post to go into but you’re totally right.
8 somebody // Mar 21, 2007 at 9:58 am
You don’t write off your mortgage payment. You write off qualifying mortgage interest. A small but important point. This means your tax write off for any given mortgage is largest for the first year, and then gets smaller and smaller until it is practically nil towards the end.
If you want to get rid of tax shelters, support simplification of our tax system. It is because of its complexity that people can crawl up inside it, rip out the insulation from the roof, and build these nice little shelters to shit in and stink up the place come summer, like so many squirrels that invade homes in the winter. It breeds intentional and unintentional non-compliance, confusion and feeling of disenfranchisement, and penalizes the poor and middle-class disproportionately. I like the FairTax plan, myself.
Finally, while you could buy or donate a car to avoid getting hit by a higher tax bracket, perhaps a better idea would be to put the excess money into a tax-exempt investment. 401k, IRA, yadda yadda consult your financial advisor blah blah. Then, instead of pissing it away on a liability, you get to keep ALL that money for when you need it most: retirement after SS has gone bankrupt.
9 misshb // Mar 21, 2007 at 10:13 am
Fantastic post, Somebody. Very informative and good additions to my original post.
10 Harms // Mar 21, 2007 at 5:18 pm
AMT = Alternative Minimum Tax. Its almost like a floor that is imposed on the super rich, to make sure that they can’t reduce their taxable income too low.
http://en.wikipedia.org/wiki/Alternative_minimum_tax
11 somebody // Mar 22, 2007 at 9:38 am
Interestingly, 15% of people earning $75-100k pay the AMT. According to TurboTax, next year that number will be 22%. I came within a hair of having to pay it this year, and I fall within those income brackets. I assure you, I am not super rich. The difference in what we would have had to pay would have kicked my family right in the balls. I for one, welcome our new AMT overlords.
More interestingly, all of the 2004 Presidential candidates, including Bush, Kerry, and Edwards all payed less than a 22% effective tax rate. All of their incomes fell within the 2-4 mil range. That same year I payed 26% making 79k. That was a huge wakeup call for me. If any of you are lucky enough to be successful in this country, you’ll get the wakeup call too. Else, you’ll probably just fill out 1040EZ and do a happy dance when you get back $1000, even though you might be paying a tax rate equivalent or higher to George F. Bush. The federal tax system is broken, the AMT is soon to become an oppression to middleclass families (it already is for a lot of small businesses), and in an effort to make a progressive tax system we have created a monster the truly super rich wipe their ass with while you and me pay good money and spend hours if not days of efforts merely to comply.
Seriously, support Tax reform. I don’t care which plan you pick, but it HAS to be better than what we are doing right now.
12 Keeks // Mar 25, 2007 at 7:16 pm
Hi Marie-
It’s Kueker–I’m a sporadic reader of your site…I mostly stop by to keep mentally sharp because there is always intelligent discussion–I’m always learning something.
This is one of the few things I feel somewhat qualified to speak on (especially after passing the certified public accountancy exam). Your readers, as always are pretty spot on, but I thought I’d add a few things.
As far as Kerry, Edwards, and Bush, the reason why they have low taxes is because they flow must of their income through trusts, which for tax purposes, are individuals on their own. I’m not that familar with trusts, so I’m going to pass up the trust/estate discussion for now.
On tax shelters and the AMT, many of these tax shelters were done away with by the Tax Reform Act of 1986, signed into law by President Reagan (can you imagine that happening today?) by changing the code in such a manner that wouldn’t allow people to shelter income as much as they used to, eliminating many tax shelters specifically designed by the code. In 1969, Congress, in their infinite wisdom, created the AMT designed specifically to “get” the less than 200 very sophisticated tax payers who utilized tax shelters to shield their income. The AMT essentially limits those shelters from doing their job, but the TRA of 1986 did away with a lot of the tax shelters formerly used from the beginning of the IRS to 1986.
That being said, the AMT has strayed very far from its original purpose. The main reason, and the simplest to fix, IMO, is to index the stupid thing for inflation. For simplicity sake, to calculate the AMT, you take your yearly income, and get to take a much larger deduction from it right away. However, that larger deduction has stayed fairly static since 1969. Every now and then, Congress will put a band-aid on it, but it’s always touch-n-go if it’s going to be increased to a proper level. If it were indexed for inflation using the amount that was written into law in 1969, it would be approximately $175,000 and be far less dangerous to middle-class family. However, you don’t get to use many “write-offs” as you called them that we have come to know and love, such as exemptions and credits for each of your children, and state and local taxes paid, which creates a perfect storm for a)people with lots of kids who b) live in a high tax state and c) make a decent income but are paycheck to paycheck, or who have varying income from year to year and can’t properly plan for the AMT (such as a farmer, someone who gets a large bonus at the end of the year, etc.)
I have a strong advocacy towards changing the AMT because it has strayed from Congress’ original intent. However, I’m not sure I’d go along with a complete overhaul of the code. It is designed to treat like people alike but assumes that we all have a similar knowledge base. Since it is codified, you could liken to the law you’re studying. If you know all the rules and all of your options (or pay someone to figure it out for you), you can do what’s best for you. That person isn’t taking money out of the pockets of other people (not directly, perhaps the government would raise taxes on our poorest and middle-class, but this is an untenable politically for anyone).
My last advice is to not, as we say, “let the tax tail wag the dog.” You should never donate or do something specifically for a tax deduction. Donate to Goodwill because you want to, or give your car away because you have an extra or want to support the organization, but if you’re doing something specifically for tax reasons, you’re creating an outflow to get a limited inflow in return. Instead, as one reader pointed out, contribute religiously to tax-free or limited tax vehicles (some may call them your own little tax shelter). I would recomment maxing out your Roth IRA ($4,000 in 2006) and a 401(k) when you get one. Make sure you take all your deductions related to your education too–a lot of people leave that money on the table.
And by all means–please sign your return. I don’t do too many anymore (I audit governments mainly now) but if I had a dollar for every one that had no signature that I had to follow up on, well…I might qualify for the AMT
13 misshb // Mar 26, 2007 at 10:16 am
Keeks, thanks for all the great insights!
Also, hello, nice to know you’re still around
14 divine angst » Blog Archive » Weekly Law School Roundup #63 // Mar 26, 2007 at 2:27 pm
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15 misshb // Apr 20, 2007 at 8:19 am
We are studying AMT in class now and I already have a great background from this post comments
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