William Sweet, CFP®, is an Investment Advisor at Ritholtz Wealth Management. Bill has spent much of his career minimizing the impact of income taxes on investment returns. He served on active duty in the US Army as an Armor Officer for six years and was awarded the Bronze Star for valorous action in combat in 2003 during Operation Iraqi Freedom. Bill holds a degree in Computer & Systems Engineering from Rensselaer Polytechnic Institute (RPI). You can read his prior work here.
~~~
As a veteran of both the United States Army and as eight income tax filing seasons, I’ve fought some battles with Al Qaeda and the IRS, and I have the scars and combat ribbons to prove it. Between the two I’m not sure which is more evil in the eyes of the American public, but let’s assume Al Qaeda by a hair for now.
The IRS is not comparable to ISIS, of course, but they are certainly the most hated government agency. We understand that taxes are necessary for a functioning society. Yet the loss we experience as taxpayers when separated from our income often evokes an emotional response from deep in our cortex that we experience as pain. Behavioral psychology shows us that losing our wealth via taxes or from short-term investment declines hurt us twice as much as the gains make us feel good. So the desire to reduce or defer paying income tax is very strong.
I’ve seen people do some really, really dumb stuff to reduce or mitigate that pain, and I thought that I’d share some of them with you today. The names and identities of the perpetrators have been altered to protect the guilty.
To be clear: do NOT try any of these.
• Make Less Money
This is the king of stupid tax moves. The tax rate is never 100%, so you as a taxpayer are always – ALWAYS – better off if you go out and produce additional income. Even if that results in additional income tax.
Your goal each year should be to maximize your wealth, not minimize your taxes. Paying large amount of income tax on a huge annual income is a good problem to have!
Probably the highest taxpayer in the union is a high wage earner living in New York City making $1 million or more. She pays 39.6% to the IRS, 8.8% to New York State, 3.9% to New York City, for a grand total tax rate of 52.3% (throw in an additional 7.7% for Social Security & Medicare but let’s focus on income taxes here). Yet even in that worst-case scenario, for each additional $10,000 she makes, she keeps $4,770 in her pocket, and is clearly better off making that additional income.
But for any taxpayer, the easiest way to reduce your taxes is to make less money.
• Hide Your Income
This is the second stupidest thing that people do. We know it happens because we live in the real world. We know that some people want to get paid in cash for a reason.
The IRS considers cash a valid payment for services, so accepting payment in cash or Bitcoin isn’t a legal way to shield your income. If you are not reporting your income regardless of payment method, you are breaking the law.
It also might be a stupid thing to do for the long run. Part of the total tax that you pay goes into Social Security and Medicare that qualifies you for retirement income and medical benefits in the future. If you habitually under-report your income today, you will receive a lower payment when you go to file for Social Security retirement income in the future. I’ve seen this happen to retirees and it is not a good outcome.
The benefits are calculated in such a way that you could receive a higher payout in retirement than the sum of your tax paid while working, particularly if you have a long life expectancy.
Plus, it’s illegal. So there’s also that.
• Make Up Expenses & Deductions
Just like hiding income, making up false deductions for charities and business expenses is illegal and definitely not a good idea. Effectively it’s the same thing.
I am guessing that charitable deductions are the most abused part of the tax code. People simply make stuff up all of the time. That doesn’t make it right.
One of the biggest myths in tax filing is that there is somehow a “safe” level of deductions that you can claim and avoid an audit. The truth is that audits and reviews happen somewhat randomly and while there are things that can trigger a higher probability of an audit, there aren’t defined thresholds or triggers that carry over from year to year. There’s no IRS manual that defines a “red flag.”
There also aren’t generally any “allowed” deductions without documentation – just about everything needs to be substantiated. In a recent tax court case, a long-distance trucker claimed about 59,000 of miles as tax deductible at roughly 50 cents per mile for a total deduction of about $30,000. Yet the tax court threw out the entire deduction because the taxpayer didn’t document business miles in a daily log, saying that it was “simply too much” to do. That laziness cost the taxpayer nearly $30,000 in write-offs plus accuracy penalties and interest.
If you’re going to claim a deduction on a tax return, you’d better be able to prove it, or it didn’t happen in the eyes of the IRS. Keep your records, peeps.
• Move To Another State Without Thinking It Through
High-income taxpayers have a compelling reason to move from a high-tax state to a low-tax state. Highly-compensated executives or sports athletes are a good example. New York State and New York City taxes combined on $1 million are hit by about a $127,000 tax bill, vs $0 for a taxpayer living in Texas, Florida, Washington, Alaska, Nevada, South Dakota, and Wyoming.
Yet middle-class taxpayers often have significant in-state tax advantages, even in the northeast. New York and New Jersey allow for a $20,000 pension & IRA exclusion for seniors, while Pennsylvania doesn’t tax them at all. If the cost of moving and travel back and forth to visit the kids exceeds the tax savings, you just made a mistake.
Plus, states like Florida and Texas have bills to pay and generate revenue, just in other ways, such as via fees or sales tax. There’s no magical land you can escape to within the USA and not pay any tax at all. I’ve had retirees move to other states and enjoy the standard of living, but middle- to low-income retirees may not experience tax nirvana elsewhere (although the cost of living is generally lower outside of NY/NJ/CA).
• File Separately
In my experience, it makes sense to file separate tax returns for a married couple about 2% of the time. The situation is usually two high-income earners ($200,000+ each), usually without kids, who are subject to what amounts to a high-income marriage penalty. Filing separately avoids that penalty.
When I get someone ask me to file separately it is usually because they suspect the other couple’s actions are somehow leading to lower refund, such as an adjustment in one spouse’s tax withholding. It does make sense at times to file separately, but it is rare.
In conclusion, report all of your income, document all of your deductions (for a minimum of three years), and don’t make decisions without examining the secondary and tertiary effects. If you want a big tax refund next year, the easiest way to make that happen is to increase your tax withholding at work, since that’s all a refund is anyway – the IRS paying you with your own money. Do that and avoid these dumb things and you’ll be happily in refundland next tax season.
What's been said:
Discussions found on the web: