Thursday, March 5, 2015

Reflections on Our Annual Visit From the Taxman

Your Money Milestones by Moshe Milevsky contains an interesting chapter on your relationship with the taxman. He starts with an cruel experiment conducted by the state of Minnesota Department of Revenue. In advance, they warned 2,000 taxpayers that they were part of a group that had been selected at random for an extremely through audit. The Department of Revenue divided the group into high, middle, low income groups as well as groups that had more or less opportunity to under-report their income.

How would you react if you received such a letter?

Not surprisingly, the middle and low income groups reported more income and claimed fewer exemptions than in previous years. However, to the surprise of the revenue agents, the wealthiest group claimed less income and more deductions. They concluded that the wealthy subjects were preparing for a fight. They did not view their tax rate as a given but rather as a negotiation between their lawyers and accountants and the state of Minnesota. As in any such negotiation, the buyer starts out with a lowball offer. The vendor then counters with a ridiculously high proposal. After several hours or days of squabbling, both parties will finally arrive at mutually acceptable terms. The merchant will then sell the same item to the next customer for an entirely different price. In such a world there is no such thing as “true value” only an ever varying discovery of the law of supply and demand in real time.

The wealthy victims are correct in their assumption.

As readers of this blog know, I gave up doing my own taxes back in 1987. I was attempting to report the purchase of our first home to the IRS. I asked several different agents the same questions. I was getting different answers that didn’t seem to track with the IRS publications I had in my hand. I was scared. The CPA showed me a five foot long shelf of 3 ring binders that contained the current tax code. He explained that he received about 50 new pages in the mail every week. He then had to pull out the old, out of date pages and replace them with the new pages. I expect that service is now on line. He also informed me that the tax code doesn’t say what the tax code says it says. The tax code says what court decisions say the tax code says. That changes with every new decision. When the CPA discovered that I had rented the home back to the seller for a couple of months since the construction of his new home was running behind schedule, he smiled like a hungry shark looking at a fat game fish. I had converted rental property to real property, giving me a $3,000 deduction!

I firmly believe unless your life is reasonably simple, you need as CPA in your corner. There are over 85,000 pages in the tax code. How they are going to be interpreted is constantly changing. Unless you are a professional, there is no way you can deal with the IRS by yourself.

The author is puzzled by the number of people who initially overpay their taxes so they are certain to receive a refund. Of course over-withholding gives the Government an interest free loan on your money. Why would you do that? The math says that is a bad idea. However, back in the day when we didn’t have anything like a six month emergency fund, an unexpected tax bill that hit at the wrong time could have been extremely painful. It simply was not worth the risk. Today, I want to be reasonably certain my withholdings and estimated taxes come within plus or minus $1,000 of my final tax bill. Back then a $600 shortfall could have been a disaster. Back then my car wasn’t worth $600.

Savings bonds were another technique I used to “smooth” our inflow and outflow back when we didn’t have much in the way of inflow or outflow. As a supervisor, I had to run the savings bond program and the blood drives on my shift. If you want to ask your troops to participate in such programs, you had better be the first in line to volunteer. I would allow the savings bonds to stack up until I had an unexpected need. After six months you could cash them out receiving principal and some trifling amount of interest. It was just another way to augment what I then called, “working capital.” Today I would call it the emergency fund.

Finally Milevsky explores the taxman and your mutual funds. Generally mutual funds report pretax gains. It turns out that funds that have very high pretax returns may rate much lower than other funds with lower pretax returns after taxes are paid. Mutual funds generate unrealized gains that are not taxed; interest income, short term gains, and dividends that are taxed as regular income; and capital gains that are taxed at a lower rate. I remember, back in 2008 there were people who sold out their mutual funds at a loss who ended up with a net tax bill. If the mutual fund sold out underlying shares at a profit before or during the collapse, the unfortunate investor could end up paying taxes even though he was losing money. It all depends on what gets taxed and what offsetting deductions are currently allowed.

Let me add for free that making an investment for tax reasons is almost always a bad idea. However, not including the impact of taxes in your considerations before making an investment is almost always a bad idea.

Just another one of those apparent paradoxes that are a part of our financial life.

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