Five Things You Gotta Know About Taxes

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By Roy Lewis
September 7, 2001

There are certain things that you must know in life: Don't touch a hot stove. Look both ways before crossing the street. Always say "please" and "thank you." Don't try to shoplift 20-pound turkeys. And there are hundreds more of these essentials that you must know to get through life.

Some of these "must-knows" have to do with taxes. While they are just a portion of your real life, taxes are a very large portion. (Just take a look at the money taken out of your paycheck next payday.)

So come and sit around the campfire as your Uncle Taxes tells you about the five tax essentials.

1) Understand the tax impact of any transaction before you enter into it!
Too many times I hear stories about people who made horrible tax errors because they got ahold of some bad information. Here are some of the common misconceptions out there:

  • "I'm buying a home, and I'm going to save a ton in taxes!" (Perhaps, but not always. See Tax Savings on Your Home Purchase.) 
  • "I'm taking an early distribution from my retirement account because it'll only be taxed at 20%!" (Completely untrue. The 20% is the withholding only; the actual tax and penalties will almost always be much greater!)
  • "I'm getting married, and filing jointly will save me mucho taxes!" (OK, so marriage is not exactly a "transaction" -- unless there's a dowry or catalog involved. Regardless of how you acquire your spouse, though, you'll have to deal with the marriage penalty.)

If you are contemplating a transaction, either take the time to research the tax consequences or take the time to engage the services of a qualified tax pro.

2) Understand that YOU control much of your tax destiny
It's true that taxes are certain, but the amount of taxes that you pay aren't as certain as you might think. Consider the kid that, at an early age, begins working and depositing some money in a Roth IRA instead of a regular brokerage account. The decision to invest in an account that offers tax-free growth could add tens of thousands of dollars to his retirement nest egg.

You can buy a home or rent, the decision is yours. There are a number of non-tax issues that will drive that decision. But that decision does have a tax consequence, now and in the future (in the form of not only interest deductions but also the potential tax-free sale of the home in the future).

How about pre-tax savings in the form of a 401(k) or other employer-sponsored retirement plan? Sure, you can decide not to make contributions -- and not reduce your taxable income -- instead using that money to go out to a dinner and a movie more often. But you'll also be paying more in income taxes than the person who is taking advantage of his or her 401(k).

It might take some work, effort, and up-front sacrifice, but you really can lower your tax liability with some smart planning.

3) Don't let the tax tail wag the dog
Don't make an economic decision based purely and entirely on the tax issues involved. Sometimes it might work out for you, but in many cases you'll be very disappointed. Remember that taxes are still a percentage game. That means that, in the 27% bracket, a tax deduction of $100 will only save you $27 in taxes. What happened to the other $73? Gone forever. So when somebody throws money away and glibly claims, "It's OK, it's a write-off," remember that there might be tax benefits, but some real, live cash flew out of this person's pocket.

Instead of looking only at the tax benefits of any transaction, instead look at the economic benefits of the transaction, and then apply the tax rules to provide the maximum tax benefits. The more you focus on the economic realities of the transaction and then maximize the tax benefits, the better off you'll be.

4) Get and keep those records
Record keeping is key. Remember that deductions and credits are not a part of your birthright. Instead, they are given to you out of legislative grace and largesse. You have to prove those deductions. And the only way to prove those deductions is to maintain the underlying records.

Every year, I talk to folks who tell me how much they contributed in clothing and furniture to their local charitable organization... but just didn't stop to get the receipt. No receipt, no deduction. Period. Consider somebody in the 30% combined federal and state tax bracket. A $500 contribution would save them $150 in taxes. Since it might take about 10 minutes to grab that receipt, that tax saving would equate to an hourly rate of about $900/hour. So is it really that much of a hassle to get the receipt? 

Keep those records. Keep them safe. You never know when Uncle Sammy might want to see them (read: audit).

5) Understand the basics of the tax laws as they apply to you 
Knowing the rules and reducing your tax liability (and possibly penalties) is an ongoing process. It doesn't happen just once at the end of the year when you're meeting with your accountant. If you understand the laws as they apply to you, you'll be able to make tax-smart decisions throughout the year.

This doesn't mean that you have to understand how obscure tax issues work if they don't apply to you. But if you're planning on selling a home, it's important that you know the rules regarding that transaction. If you have business deductions, you'll need to know how those deductions can be applied. The more that you know, the better job that you can do for yourself. 

So there you have it: the five issues that you really need to know about taxes. Read them. Hold them dear. Pass them down from generation to generation. You, your children, and your grandchildren will be that much better off for it. And the only loser will be Uncle Sammy. 

Roy Lewis lives in a trailer down by the river and is a motivational speaker when not dealing with tax issues, and he understands that The Motley Fool is all about investors writing for investors. You can take a look at the stocks he owns as long as you promise not to ask him which stock to buy. He'll be glad to help you compute your gain or loss when you finally sell a stock, though.   

This forum and the information provided here should not be relied on as a substitute for independent research to original sources of authority. The Motley Fool does not render legal, accounting, tax, or other professional advice. If legal, tax, or other expert assistance is required, the services of a competent professional should be sought. In other words, if you get audited, don't blame us.