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Sunday, August 17, 2014

Taxes: Your American Right to Lower!

I've never met a person who likes to pay taxes.  Never.  They may not mind it.  They may consider paying taxes as something that needs to be done for the common good.  But again, "like," that is too strong of a word in all conversations I have had.  If you currently belong to the camp of "not minding," or of "it's good for the common good," I want you to ask yourself: Are my tax dollars being put to good use by our politicians?  If your answer is, "no," then read on.  If your answer is, "yes," then I want you to stop reading, leave this page immediately, and come back to this blog some other day, because this post, my friend, is just not for you.

The following is an excerpt from my ebook: Common Core Money: Financial Literacy for Educators and Other Professionals, Amazon Link.  It's only $2.99 people!  You're not going to get a better deal on an all encompassing financial literacy book.  It's also short and sweet for you non-avid readers.  Without further a-do:

Taxes are the single biggest enemy to wealth creation and preservation.  Many of my peers think of taxes as money that gets taken out of their paycheck monthly.  They dread the IRS and loathe Uncle Sam for jacking them of their hard-earned money.  Many love the idea of getting the rich to pay their fair share of taxes.  But when it comes to tax-saving strategies they have no insight.  I ask, “What tax bracket are you in?”  They don’t know.  The median salary for an elementary school teacher in 2014 is $41,069.  For a middle school teacher it’s $42,694.  And for a high school teacher it’s $45,177.  Source: www.payscale.com.  Without personal exemptions, that could place teachers in the 25% tax rate bracket.  (A typical administrator with pay greater than 89K could be in the 28% tax rate bracket)  Does it seem high to you?  It is!  Why?
The U.S. tax code is arranged to punish the professional, the “employee” who works for someone else.  Our government believes that structuring the tax code this way is best for the U.S. economy.  They figure that more people will want out of these crazy high tax brackets, forcing them to go into business for themselves.  In so doing these entrepreneurs will create small companies that grow into large companies, creating more jobs!  Pop quiz.  What is the fastest way to become a multi-millionaire?  Is it by becoming a highly paid lawyer or doctor?  How about working for Google as a software engineer?  The answer to becoming a multi-millionaire in this country begins with the creation of your own company.  It ends with you developing your company into one that uses scale and automation for growth.  If you can franchise your company or license a product or service and get royalties then you understand the end goal.  When you no longer need to be present for your enterprise to operate, congratulations!  You’ll be bought out by a larger company and retire wealthy.  In contrast, if you start a business and don’t have the business savvy to expand without this taking more of your time and effort, then you’ve created a lifetime job for yourself.  You may enjoy better tax-saving perks as a business owner, but if throwing all your spare cash back into the business is all you can afford to do, you, my friend, are stuck.
This book isn’t about convincing you to leave your profession and start your own business.  It’s about helping you make the best of your circumstances.  If you are in the 25% or 28% tax brackets, the name of the game then becomes how to lower your taxes.  As educators, most of our income comes from wages and salaries.  We take the standard deduction on tax returns.  As an individual you can write-off a measly $250 for classroom supplies, materials, books, and software.  Whoopee!  You can claim your dependents of course.  If you’ve withheld more than you needed to each month, you’ll get a refund.  If not, you’ll have to pay the IRS.  You won’t ever need Schedule A, Form 1040, because you won’t have any itemized deductions.  No mortgage, charitable gifts, high medical expenses, and investments = no itemizing.  Your effective tax rate will be about the same as your marginal tax rate.
The Investor Class doesn’t make their income like you and me.  They’re not employees.  They make their money from their investments.  They avoid “owning” anything and start LLC’s or an S-Corp, and get additional tax savings, not to mention personal protection for themselves within their entity.  Their assets don’t belong to them; they belong to the company.  They’re mere stewards.  During the last Presidential race a big fuss was made about Mitt Romney’s tax rate.  Instead of applauding him for sticking it to the man, people, the employees of this great nation, criticized him!  In 2011 Mr. Romney made 20.9 million dollars, and his effective federal tax rate was 15.4%.  Outstanding!  President Obama’s effective tax rate was in the 20-25% range.  My personal federal effective tax rate for 2013 was 15.5%!  Mitt Romney has multiple streams of income and most, excluding his check from the state treasury for being governor of Utah, is income from his investments.
Investments (capital assets) in America are taxed at a lower rate than wages and salaries.  Again, it’s the government’s way of getting you to participate in this free-market capitalism project we have here in the U.S.  What type of investments does Mr. Romney have?  Well, he isn’t running a sole business somewhere with all his spare time.  He’s got millions in real estate generating positive cash flow each month, and he has his Enrolled Agent rubbing her hands together come tax season waiting to depreciate, deduct vacancies, repairs, property taxes, and mortgage interest.  He probably also has a sizable equities portfolio.  Again, his Enrolled Agent not only lists the income (capital gains) Mr. Romney made from the sale of stocks or bonds, but also deducts plenty in the form of losses.  Holding an investment long term, more than one year, can lower the taxes you pay on income generated even more!  Bottom line, many educators are investment (asset) poor.  But it’s not because we can’t purchase investments of our own.  There is no law against it.  It’s because we may not have the understanding to participate in the asset race to the top, pun intended.

Tax Saving Tips, Specific to Educators & (Other Professionals Who Can Enroll)
           
It boggles my mind how many teachers aren’t taking advantage of Section 125 Flexible Benefit Plans.  If your school district doesn’t offer Section 125 Flexible Benefit Plans, then get your union folk together and make it happen.  It’s not like site administrators have the power to change anything up the ladder.  But I digress.  Now, a section 125 flex spending account authorizes your payroll office to deduct from your taxable gross income each month.  These pre-tax dollars are sent to your account with the participating insurance product company.  In my case, it’s American Fidelity.  You decide the amount you’d like withdrawn from your gross pay each month.  There’s a limit of course.  You’re allowed to use pre-tax dollars to reimburse yourself for both dependent daycare (child care) and health related expenses not already covered by your insurance.  Copay for a dental visit?  Covered.  Copay for a doctor’s appointment, also covered.  If your family is on your insurance then they too are covered for eligible expenses.  See www.afaadvantage.com for more information.  Now why would you want to have what little you already make, your taxable gross, reduced each month?
            The math makes sense!  Here’s an example:

           
It’s possible for you to have a higher net pay each month with an FSA then without one.  The trick is to figure out how much you’ll spend each year in copays, meds, and daycare; then divide by the number of pay periods.  I get paid once a month but the installments for my plan are taken ten months out of the year.  With my wife, two kids, and me, we spend about $1,000 a year in health-care related expenses.  She’s a stay-at-home mom so no dependent daycare to claim.  $100 a month, therefore, is my monthly installment for HC/DC.  This is peanuts, I know.  But it is all I need.  If you don’t end up spending enough out of pocket then you’ll have a positive balance in your flex-account at the end of the year.  This is a no-no.  Although the U.S. Treasury Department allows up to $500 to be carried over to the next year now, employers are not required to go along.  Your money could be forfeited.  You’ll also have to wait a year until the next election period to make any adjustments.
            Aside from DC and HC, you can also pre-tax retirement contributions in the form of a tax-deferred annuity.  I work in California and we have CA State Teachers’ Retirement System or CalSTRS.  This is my defined benefit pension plan.  Because I’m a public employee, I’m automatically and mandatorily enrolled in this plan.  Each month, a portion of my pay is withheld to fund my pension.  My employer contributes a similar quantity for me.  The state of California contributes a tiny portion sometime later in the year.  In contrast, non-public employees get to choose (if their employer offers one) whether or not to fund a defined-contribution plan.  These are better known as 401(k) or 403(b) plans.  Despite having the option, some employees choose not to contribute to a 401(k).  It’s a no brainer for me if my employer offered a 401(k) and they were willing to match my contribution.  Why give up free money?  As an educator, under section 125, you’re allowed to increase your retirement savings using pre-tax monies.  I have $200 taken out of my gross taxable pay each month or $2000 (ten installments) a year.  This goes into a tax-deferred annuity, 403(b), held by the same insurance product company that does my flex-spending account.  Putting it all together, $100 a month for HC, $200 a month for my 403(b), totals $300 subtracted from my taxable gross per month.
            Educators that work long careers are sometimes lucky enough to be offered a golden handshake.  When your district has too many old timers still in the books, they might offer a golden handshake.  These teachers are at the farthest end of the pay scale.  It’s cheaper to hire a beginning teacher then to keep a veteran one.  To encourage retirement, some districts offer veterans an annuity.  That’s in essence what you’re building with a 403(b), your own golden handshake.  Don’t count on your district offering an annuity at the end of your line.
Because the contributions to a 403(b) are usually tax-deferred, you’ll have to pay taxes when you begin to withdraw.  If your tax rate won’t change much over the span of your career, then it makes sense to have a 403(b).  On the one hand, you’re minimizing the amount Uncle Sam can tap into each month.  On the other, you’re adding an additional source of income for your retirement!  If you believe your tax rate will be higher once you retire, then simply consider the tax-deferred 403(b) for its potential, along with an FSA, to help boost your net pay each month.  Use the extra cash to buy paper (equities) or hard (real estate) assets, lower your effective tax rate, and pay the taxman later.
            Here’s one last point about taxes.  Are you withholding too much each month?  If you have two dependents, are you putting “0” or “1” on your W-4 form?  I realize it’s tricky to get it just right, so that you don’t get a bill from the IRS once you file your return.  This is especially true if you’re doing taxes for yourself using TurboTax or some other software.  Everybody likes to brag about how fat of a refund they got.  I shake my head in bewilderment.  Don’t they know they let Uncle Sam hold onto this money almost a year, I say to myself.  They wasted time not putting this extra cash to work.  They could’ve paid down debt or bought stock of an undervalued company, for example.  Your tax liability for each year will be whatever it will be.  You get a promotion, you buy a rental property, a change happens, and all of a sudden things get more complicated.  That’s why I suggest you employ a certified public accountant.  Don’t skip the math and go the easy route, choosing “1” or worse, “0.”  Consult with your accountant or at minimum if you’re a cheapo, use the tax formulas so that you’re withholding just enough each month.  If you’re disciplined with your money, and you’ve put it to work wisely, a tax bill at year’s end won’t kill you.  You’ll be able to stroke it.  Re-adjust the following year.  I pay my Enrolled Agent, Cheryl, about $450 for her tedious work on my return.  She’s worth twice as much!  Finally, if you’re doing your own taxes, chances are you’re asset poor.  Or you’re a glutton for punishment.  That’s okay for now.  I don’t waste my time with this hair-pulling chore.  Why should I?  The fee is tax deductible.

Note 1: An Enrolled Agent (EA) is a federally licensed tax practitioner.  Unlike a CPA or an Attorney who get their rights to practice from their state, an EA receives their right to practice directly from the U.S. government.  An EA specializes in taxation.
Note 2: Another way to minimize capital gains tax from the sale of equities is to buy shares of a mutual fund that has “low-turnover.”  When considering an investment, find the fund’s turnover rate (in the prospectus).  This is how long a fund holds its stocks for.  A turnover rate of 100% means that a fund is holding onto stocks for a year.  You want a fund with a buy and hold strategy (20% or below t-r) to minimize taxes.  The Vanguard 500 Index Fund (Ticker: VFINX) had a super low-end year 2013 turnover rate of 3.4%!  https://institutional.vanguard.com/VGApp/iip/site/institutional/investments/productoverview?fundId=0040

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