You're probably not as tax-savvy as you think you are or want to be. That's not surprising, though, because our tax code is ridiculously massive and complex. Still, we would all benefit from learning more about taxes, as the more we know, the less we may be able to pay in taxes. A survey last year revealed just how tax-illiterate many Americans are -- see how well you do with some of the questions.
First, though, a look at just how big and complex our tax code is illuminating. Folks at The Tax Foundation have noted that as of 2015, the federal tax code and regulations total more than 10 million words -- that's more than nine times the length of the entire seven-book Harry Potter series.
This has not been lost on our National Taxpayer Advocate, who, in her 2012 annual report to Congress, noted that the tax code is close to four million words long and that individuals and businesses spend more than 6 billion hours each year on tax preparation. About 59% of taxpayers end up paying professionals to prepare their tax returns for them, with another 30% using tax-prep software that is also typically not free. According to WalletHub, the average American spends about 16 hours and $270 preparing their tax return.
While it's not surprising that many of us don't know a lot about taxes, it's still a troubling situation, as being unsavvy can be costly. Below are some of the questions that that the folks at NerdWallet asked Americans in early 2015. See if you know the answers.
Question 1: Is the money you put in a Roth IRA pre-tax or post-tax?
c. None of the above.
Question 2: What is a Flexible Spending Account?
a. A tax-exempt savings account exclusively for health benefits.
b. A tax-exempt savings account that allows you to make home improvements.
c. A tax-exempt account for medical purposes or child care.
Question 3: Which of these is the worst mistake?
a. If you owe, not filing your taxes by April 15.
b. Filing but not paying your taxes by April 15.
c. You are owed a refund, but you file late.
d. You are owed a refund, but you don't file at all.
The answer to Question 1 is that Roth IRAs are funded with post-tax money. You fund a traditional IRA (and 401(k), for that matter) with pre-tax money, subtracting the amount of your contribution from your taxable income. It grows on a tax-deferred basis and then is taxed when you withdraw it in retirement. A Roth IRA (and Roth 401(k)) takes post-tax money and lets you withdraw money in retirement tax-free. Most people surveyed thought Roth IRAs took in pre-tax money; only 42% got it right.
The answer to Question 2 is that a Flexible Spending Account (FSA) is a tax-exempt account for medical purposes or child care. You can contribute up to $2,600 per person to a health FSA in 2017, and up to $2,500 per person (or $5,000 for married folks) for a dependent care FSA. The money can be used tax-free for qualifying expenses and it's mostly use-it-or-lose-it each year, with only $500 allowed to be rolled over into the next year. Fewer than 50% of respondents got this one right.
The answer to Question 3 is the last option -- not filing at all. You may not always owe taxes to Uncle Sam, but you usually still have to file your tax return. Only 36% of respondents got this one right.
A few more questions
Here are a few more questions covering important tax information:
- Question A: Is a tax deduction or a tax credit more valuable?
- Question B: Can you claim some deductions even if you don't itemize your deductions?
- Question C: Is there such a thing as a Taxpayer Bill of Rights?
The answer to Question A is that credits are more valuable. If you are in the 25% tax bracket and you have a $1,000 deduction, you'll save $250 by not having to get taxed on that $1,000. If you have a $1,000 credit, though, your tax bill will shrink on a dollar-for-dollar basis -- you'll save $1,000. Some credits are even "refundable," meaning that if you only owe $800 in taxes and you have a $1,000 refundable credit, you can get $200 back as a tax refund. There are gobs of various deductions and credits available, for anything from adopting a child to moving expenses.
The answer to Question B is that you can claim "above the line" deductions without having to itemize deductions. That's because they're claimed before you arrive at your adjusted gross income (AGI). They lower your AGI and therefore lower the taxes you pay based on your AGI. Some above-the-line deductions include alimony paid, educator expenses, student loan interest, traditional IRA contributions, and much more.
The answer to Question C is yes. There is a Taxpayer Bill of Rights, assuring us rights such as the right to be informed, the right to quality service, the right to pay no more than the correct amount of tax, the right to challenge the IRS, and more.
What to do
Clearly, the more you know about taxes, the more you can save. A little time spent reading up on available credits and deductions, for example, can really pay off. Using tax-prep software can also be helpful, as it will likely ask questions to find out which tax breaks you might qualify for.
Another smart move for many taxpayers -- at least those with non-simple situations (such as multiple jobs, homes, and life changes) -- is hiring a tax pro to prepare your return and help you strategize. Yes, it will cost some money -- possibly a few hundred dollars for a good pro -- but you may well reap much more than that in tax savings and a bigger refund. A good tax pro will be up on the latest tax-law changes and will know far more about the tax code than you do. Don't just hire anyone, though. Ask around for recommendations. Consider hiring an "Enrolled Agent," a tax pro licensed by the IRS who is authorized to represent you before the IRS if need be. You might find one through the National Association of Enrolled Agents website.
Longtime Fool specialist Selena Maranjian, whom you can follow on Twitter, owns no shares of any company mentioned in this article. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.