A very successful businesswoman told me that she once asked her accountant why he did not take advantage of tax breaks for investing in new equipment. His answer was, “We’re accountants. We don’t know anything about investing.”
As a result, they leave money on the table. Don’t leave money on the table because you are not an expert.
That’s easier said than done, but there are things you can do to increase your value to your employer–for example, by getting certified in other areas that interest you or developing new skills that will make you more desirable to other employers.
Trying to reduce your taxes by maximizing your deductions is like trying to lose weight by adjusting the numbers on the scale.
It’s not that you’re rooting for the IRS, or that they will punish you if you don’t play by the rules. It’s just that most taxpayers are better off following their normal routine and letting tax software handle any adjustments for them. If you try to optimize, you will very likely do worse than is possible through ordinary care.
For example, when your income varies from year to year, your tax rate can vary too, just because of how the brackets are set up. Filling out your tax return is like choosing which pair of pants will go best with a particular shirt: proper behavior is to pick whatever pair is in front of you without thinking about it too much.
The goal in filing taxes is to give yourself some plausible reason why what you did was legal. You do not need to find some special combination of deductions that no one else has ever heard of, or that the IRS has never heard of either—though if you do manage to get away with that, more power to you!
Let’s say you have $100,000 in taxable investments. If you put it all in the bank at 1%, you’d earn $1,000 a year in interest.
You can invest your money as follows:
* Put $10,000 in the bank as before, and lend the rest to a friend who’s starting a store. Charge him 10% interest, and he’ll pay back the $10,000 after a year. The interest will be tax-deductible (since it’s a business loan) and the principal will be untaxed (since it’s a capital gain). You’ll end up with $10,000 + $10,000 * 0.1 = $11,000.
The other kind of business that is easy to understand is a business that does something you can’t do at home.
Some people are natural plumbers, or electricians, or car mechanics, or house painters. If they run their own businesses, they can make money without much education. But no one is naturally good at accounting. And yet everyone needs accounting. It’s boring and tedious to learn, but it’s important to everyone who runs a business or owns an investment.
The problem with accounting is not that it’s hard or complicated; it’s that it’s dull. The people who want to do dull things are not the same kind of people who are drawn to starting businesses. As a result, there are lots of small businesses being run by people who have no idea how to keep track of their income and expenses. They just get tax statements from their accountant every year. Some of the time the numbers on these tax statements are wrong because the accountant made a mistake. But often they are wrong because the business owner did not understand what he was being told.
Be an active investor!
That’s what everyone is saying these days. But in practice, most people leave their investments to others. Their money goes into some mutual fund or 401(k) plan, and they don’t check on it for years.
And that’s a shame, because that money is theirs—it’s coming out of their salaries every month—and what happens to it matters enormously to their lives. It determines whether they can retire when they want; whether they get to send their kids to college; whether the bankrupt government can take away everything they’ve earned in one fell swoop (which is starting to look like the plan).
This is not a game. You are playing against professionals who know what they are doing and will ruthlessly exploit any mistake you make. This means you need both skill and luck on your side. But for skill, you also need to be paying attention. If your money is on the table, watch how it gets played with!
There is a lot of talk these days about tax fairness. The government takes too much money from the wealthy, and they aren’t spending it to help the poor. We should increase taxes on rich people and use that money to support programs for the poor. It’s all nonsense.
Taxes are not for redistributing wealth; they’re for raising revenue. They’re not designed to take money from one group and give it to another; they’re designed to stop people from avoiding taxes altogether.
Students of economics learn early on about “Ricardian Equivalence”: If you cut taxes, you decrease revenue by stimulating the economy, which leads people to earn more income, but because of the lower tax rate, they don’t save as much of it, so total saving goes up only by the amount of the tax cut. So a tax cut doesn’t leave more money available to spend on social programs.
I believe this theory is wrong. I believe that cutting taxes leads people to save less and spend more, which leads to greater consumption and increased production, which leads to increased tax revenue.
When the president says he wants to “grow the economy” or “create jobs,” what he means is that he wants the economy to grow and create jobs. But politicians are in the business of winning elections, not creating wealth. The way they win elections is by giving money and other goodies to their voters. The more they can get away with giving away, the more likely they are to get re-elected.
The best way for a politician to give away money is, of course, to let someone else pay for it. That’s how we end up with tax loopholes: if you don’t like something that costs money, offer tax breaks for people who do like it. This way you get your voters’ support without having to spend any of your own political capital; all the cost gets hidden in the fine print no one reads.
The trouble is that this kind of fine print may come back and bite us on the ass: we get all excited about a new industry or a hot new product and then find out later that we’ve given away so many tax breaks we can’t afford to keep it going when it falls out of fashion or turns out not to work as well as everyone thought.