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Reality Check: Debunking Five Tax Myths

taxes

With the April 15 deadline passing, it is too early to fully assess the debut tax season for the Tax and Jobs Act of 2017.  Taxpayers, tax return preparers, and lawmakers warily (and wearily) navigated the impact of changes,  while the vast majority of taxpayers anticipated their tax bill to be lower.

As  tax filing season progressed,  there were early reports of lower than expected refunds.  This dissatisfaction was likely a result of adjustments made in the tax withholding tables early in the year,  so that taxpayers could immediately feel the benefit of the shiny new tax law in their paychecks.   Unfortunately, many taxpayers did not equate the increased paycheck in the near-term with a lower refund at filing time.  Further, many people rely on the annual refund as a vehicle for savings, or funding other recurring costs such as tuition, vacations, and home improvements.

We anticipate that segments of the population will be vocal about higher tax bills.  For example, tax changes eliminating personal exemptions and reducing itemized deductions will likely have an adverse tax impact on many parents with college-age children. 

Simple tax law changes can create complications, which is not new when it comes to tax reform.  Trade-offs and changes in the original bill occur during the legislative process — and there are unanticipated outcomes.  Given the complicated nuances to tax rules, minimal tax knowledge among the media outlets, and tax law misinformation shared on the airwaves, it's not surprising that the majority of taxpayers lack reasonable expectations when it comes to tax changes.

So it's time for a reality check, and an opportunity to help debunk common tax myths...

  • Myth #1: "A good measure of my tax situation is the size of my Tax Refund." First, let's unravel this often misunderstood tax terminology.   Many  people measure or describe their tax situation by the size of the refund.  

    Wife: “George, how did the new rules  impact our taxes?"  Husband: “Great, Martha! We will get a large refund this year."  Let’s break this down and see why Taxpayers would be better served by mainly focusing on the tax liability (or cost of the meal, as indicated below).

    Let’s say George goes to a restaurant and receives a $15 bill for his meal.   After paying $20 in cash, he receives $5 in change (his refund) from the server.  If George then raves online about his five dollar refund and posts a picture of his meal and gives the restaurant a 4-star review,  he would be trolled for not paying with a $50 bill to get an even bigger refund.  

    Taxpayers like George need to stay focused on each element of the refunda calculated tax liability on one hand, and payment on the other.  
  • Myth #2: "I need to stop my income, it's costing me too much in taxes."  This is a frequent idea and depicts a misunderstanding about tax rates.  Since the tax rates are a percentage of income, it's always beneficial to earn more.  If you are concerned about the tax impact of additional earnings, speak with your tax preparer.  Yes,  tax rates may increase as income increases; and while there is less after-tax income, it is not usually a disincentive to receive more money.

  • Myth #3: "I need to get a mortgage so that I can increase my deductions."  This is not always true or beneficial, particularly with changes in the new tax act.  The "mortgage decision" is usually based on  a need for financing or to keep liquid funds on hand.   Also, one should evaluate the mortgage interest rate against other investment alternatives.  The tax benefit of a mortgage interest deduction may also be a significant factor in determining whether a home purchase is affordable.   

  • Myth #4: "Tax credits and tax deductions are the same thing."  Confusion about tax credits and tax deductions is very common among those who do not regularly work with taxes.  Let's set the record straight:  Credits reduce taxes dollar for dollar, while deductions reduce taxable income, which, in turn, are subject to the tax rates. Thus,  a $100 tax credit reduces the tax liability by $100.  A tax deduction of $100, on the other hand, reduces taxable income by $100, providing a $30 savings (assuming you are in a 30% tax bracket.  See Myth #5 below.)  Definition:  A tax bracket is a range of income taxed at the same rate.

  • Myth #5:  "My tax rates are based on my total income."  The term tax rate has various meanings.  Your marginal rate is the tax rate charged on your last dollar of ordinary income and is derived from the tax tables or the tax bracket. Your effective rate is your tax liability divided by your income.  Your marginal rate is important for determining the tax cost/or saving in evaluating a change to your income or deductions.  Your effective tax rate is what you complain about for paying too much taxes — or brag about for paying little in taxes — at a cocktail party.

We all remember Benjamin Franklin's famous quote, "In this world, nothing can be said to be certain, except death and taxes."  However, Ben might wave “certainty” with respect to the amount of taxes.   While the new tax rules have gained simplicity, change takes time.  Assessing the true impact of changes takes more time.

Many of us are rooted in rules that are years beyond their expiration date.  Taxes and, more importantly, the never-ending changes to tax law, have become part of the DNA of our economic system.  Likewise, it might be helpful for you to spend a few minutes reviewing your tax returns with your tax accountant or your financial advisor to avoid falling to tax myths. Uploading your tax return to the McKinley Carter portal is an excellent way to keep your advisor updated and in position to evaluate the impact of your taxes on investment decisions.  

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