Entries Tagged 'Taxes' ↓

So we finally finished doing our taxes for the year of 2007. Since it was the first year for us to do taxes together it was a little more annoying than usual. Things used to be as easy as taking the standard deduction and reporting my W-2s and investment income. This year I had to read a lot more about filing as a married couple and the various marriage penalties. There were a few things we could have done to reduce our taxes. For example, I told the hubby to increase his 401k contributions last year, and he did do it, but his company seems to not have updated his contributions percentage. Since we didn’t get married until end of August last year I never looked at his paychecks for most of the year. It seems that financial planning for engaged couples really should start at the beginning of the year they intend to marry because the tax status is based on their marital statuses at the end of the year. By the time I got the hubby’s W-2 for last year it was too late to contribute more to his 401k for 2007. Another thing is that our W-4 status was wrong for most of last year because we didn’t change it. I don’t think that affected our taxes so much, though.

The end result is that we owe money this year simply because we got married. Both of us were bumped into the next tax bracket due to the marriage penalty. If we were both single we would both get tax refunds this year. However, we did donate a good amount of money so the tax bite isn’t so bad, and we don’t have a problem paying it off. This year, we are putting the following plans in action to reduce our taxes:

1. Got the hubby’s HR to up his 401k contributions - The hubby contacted his HR and now his 401k contributions are at the same level as mine. Last year I saved a lot more than him in my 401k and it is only fair that he gets to save as much in his own retirement account. This move reduces our combined adjusted gross income, and it means we will pay less taxes as a couple.

2. Donate more money - We are upping our donations each month to our church and charities because we have been blessed financially and we want to give a bit more out. I rather see the money go to causes I care about than the IRS or the Franchise Tax Board. Some people said to me that it is a dumb plan because I don’t really save money by giving money out, but donating isn’t about saving money.

3. Put more in tax advantaged funds and bonds - Treasury bonds do not incur California state tax and the Vanguard California Tax exempt money market fund is exempt from both Federal and State taxes. I am already putting money into these funds, and I plan to add some more. This is in our joint account and we can use the money for a house in the next couple years.

4. Maybe have a kid? - Our plan is to have a kid two years after we get married, and though a kid would reduce taxes he or she would increase our expenses quite a bit, too. We can’t really control the exact time of conceiving, but hopefully it will happen in a year or two.  I am reading up on this quite a bit.  I think it is best for us to have a kid sooner rather than later because each year the cost of having children goes up.  Also, I think the hubby’s mom is so lucky to have two adult children out of the house at the age of 46!  I want to be a young empty nester in twenty years.

The funny thing is, we still qualify for the economic stimulus tax rebate this year, but it is just enough to cover the taxes we owe so we will come out even.  Since we owe taxes I am trying to write the checks as late as possible and send out the returns in April.   Hopefully this year we will not owe anything!

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Lately quite a few people have been asking me about my opinion on the political candidates and who I would vote for. I give a different answer everytime because I am not an American citizen and therefore I don’t have the right vote. Sometimes I jokingly say, “I hail to Beijing!”. Though in reality, the actions of the American government really affect me a lot more than those of the Chinese government since I am a permanent resident of the United States. I don’t particularly like politics in America because a lot of it is a bizarre popularity contest. (e.g. Hillary wins New Hampshire because she got emotional? What?) However, I am pretty clear about what I want the next president to do with my money. Here is my wishlist from the sidelines of the current electoral circus:

1. Get Rid of Social Security Taxes (At Least for Those Who Won’t Benefit) — Social Security Tax is the tax that irks me the most because I know as it is I will never benefit from it. It’s a system that lets older generations spend the money of the younger generations and everyone knows it is not really sustainable. I hope the next president actually does something about this because the past presidents always talk about Social Security reform and never take action. I am all for abolishing the system all together or changing the system into some kind of enforced retirement saving so that the person who paid the tax actually gets the money back in the end (the entire amount plus investment gains). If the government really wants a cut they can make sure the money all go into treasury bonds, but in the end the person who paid the money in the first place gets the money for retirement. I think that is the only fair thing to do.

2. Cut Down Spending — I think the government really spends our money on a lot of useless stuff or just mindlessly overpays for goods and services. I heard on the radio a few months ago that a company exploited the government’s billing system and billed the Defense Department millions of dollars for a few screws. Of course the company in this story committed fraud and was discovered, but how many of these cases are out there in other contracts? The government needs to be lean and frugal with their spending and actually examine their purchase orders one by one. My previous company’s CEO took frugality to the max and made sure every purchase was first researched on a shopping comparison engine, and then he signs the purchase order. The government can also cut down on inefficient personnel. It seems like a government job is so stable that people never worry about being fired. Well, maybe some slackers should be fired and government services as a whole may improve. I am just proposing a couple ways the government can cut down on spending without cutting services.

3. Simplify the Tax System but Don’t Raise the Taxes — I don’t really mind that the tax system is tiered or that we have to pay income taxes, but I don’t like how ridiculously complicated the system is. I have written previously about the AMT and the marriage penalty and I think all these weird exceptions should be ironed out and simplified. It is not easy, but something has to be done. Also, it’s very likely that a lot of the Bush Tax Cuts will expire in 2010 if the next president isn’t supportive of the tax cuts, and I think a sudden change back to higher taxes would be hard to swallow for a lot of Americans. It would be best if the next president just kept the tax cuts where they are.

4. Fix the Way the Consumer Price Index is Measured — I have also written about this before. Basically the government really never reports the true inflation we face everyday. I hope they would at least include the actual costs of things in the measurement of inflation instead of the substitute costs. Anyway, this is a hairy issue that affects a lot of people that I never hear about from the presidential candidates. If we have a more accurate CPI we can have fairer raises and better prepare for our future through savings and investments.

5. Encourage the Nation to Save — As long as I have lived here we are encouraged to spend because consumer spending is what keeps our economy going. What if there are just a few changes that encourage people to save? For example, raise the Roth IRA contribution limit, or eliminate federal taxes on treasury bond interest income? What if we had a president that advocated that frugality is the path to the American Dream? How would American change? How would the world change?

Anyway, there are a lot of other issues I care about, but what I say doesn’t matter because I am not a citizen. I hope something good comes out of the new presidential regime and I hope voters examine what the candidates wish to do instead of being in love with their personalities. Good luck America, and feel free to say what you want to see happen here!

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Albert Einstein once said that “the hardest thing to understand in the world is income taxes”. I definitely agree with him and I think everyone’s lives would be a lot easier without income taxes. Recently I came upon something called the FairTax. It is a bill in Congress with a good amount of supporters and its goal is to establish a national consumption tax of 23% and eliminate all income taxes. I went to FairTax.org and read about the bill in detail. I must say that it is an intriguing and revolutionary bill, but is it really a fair tax?

The main point of the FairTax is that rich people spend more money so they will be taxed more. Since it is a tax on consumption instead of of income it encourages saving and investment. There is also a set level of expenditures that are not taxed. For a couple in the continental United States the limit is around $20,000. I do find this attractive because it should encourage people to spend less so that they can keep more. However, I can see how this can backfire and people will spend more than before because their paychecks will look much bigger and they will feel rich. If everyone’s social security and federal taxes were suddenly gone, many people will find their paychecks to be 20 to 30% bigger. That’s a huge increase on paper and psychologically it will induce more spending.

I am also skeptic about this tax because I still think that the rich will benefit more from the plan. There is a basic cost of living for survival no matter where you live. Suppose that amount is $30,000 a year for a couple somewhere in the United States. So they’re not taxed on the first $20,000 they spend and on the next $10000 they need to pay $3000 under the FairTax (The tax is $3000 on $10000 because $3000 is 23% of 13000). Suppose one couple in this area makes $35,000 a year and another couple makes $70,000 a year and they both spend the minimum they need to survive. The couple that makes $35,000 saves $2,000 because they spent $30,000 and paid $3,000 in taxes. The couple that makes $70,000 saves 37,000 instead, and pays the same $3,000 in taxes. The effective tax rate on the poorer couple is 8.6% while the effective tax rate on the richer couple is 4.3%. Is this fair? I think it’s debatable, but under the regular tax system the poorer couple probably could have qualified for a lot more tax cuts. Though, since these couples can’t escape the 7.65% payroll taxes on Social Security and Medicare, even the 8.6% tax rate isn’t too bad. No matter how we cut it, those who have more money will benefit more because they can live on a smaller portion of their income. The FairTax counts on the fact that richer people spend more money, but I don’t think that’s always true.  If you look at Warren Buffet, from all available reports it really seems that he doesn’t spend that much on himself every year, but his investment income is enormous.  If the FairTax were implemented, a gargantuan chunk of tax revenue that could have been collected from frugal billionaires like Warren would be gone.  It’s great for Warren, but is it really feasible for the United States government?

Another thing I don’t consider fair about this tax system is the minimum poverty rate. They really can’t say that $20,000 is the poverty rate throughout the whole country. In expensive counties like San Mateo and San Francisco a couple usually needs more than $20,000 a year just for the necessities. The average rent for a 1 bedroom is around $1000 to $1500 in these counties. If they really wanted to be fair they would adjust the poverty rate for each region. It shouldn’t be so hard because they already have a cost of living system in place for the military where soldiers get different cost of living allowances in different parts of the country and world. The same system could be used to adjust the minimum poverty rate in each region.

This tax is also a huge boon to the bottom lines of corporations because the high corporate taxes are eliminated. The FairTax proponents argue that this is a stimulant to the economy because corporations would be able to hire more people and produce more with the income they have. Also, they argue that prices will come down because corporations will no longer have to pay their employees’ social security and medicare taxes so corporations can create cheaper products. Most of this sounds good, but I imagine it would be harder for small businesses to start because there will probably be legal barriers. Also, big corporations probably will not lower their prices just because their costs are lower. The whole point of capitalism is to make as much money as possible. If a consumer is willing to pay $100 for something, a corporation would not mark it down to $50 just because their manufacturing process suddenly became more efficient and they can produce twice as much. A smart corporation would continue to charge $100.

Anyway, this is an issue to watch for in the 2008 elections. FairTax.org has a list of presidential candidates who have stated in public whether or not they support the proposal. Personally, I am wary of this proposal and I agree with what Giuliani and McCain said. This is a new system that will take a lot of effort to implement and get used to. It also needs to be fleshed out further and looked at more carefully by more people. I doubt that it will be passed in the near future because there is just too much logistics involved. I am glad that people want to change America’s crazily convoluted tax system, but I am afraid that there is really no system that can be simple and equitable to everyone. I think the FairTax is definitely an interesting idea, but it probably won’t get enough support to be passed into law in the state it is in now. Additionally, all 50 state governments will have to agree to it and implement it, and that may be more difficult than just getting it passed in the Congress.

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Recently I read a headline that since congress still isn’t sure about what to do with the alternative minimum tax, millions of potentially incorrect tax forms are going to the government printers. Additionally, tax returns will probably be delayed next year since people who use the incorrect forms will have to file an amended return. I haven’t even heard of the alternative minimum tax until I started working in 2005. Apparently a lot of my peers aren’t aware of this tax either. Even if they do know what it is they’re pretty confused about it. I am actually pretty confused by it, too, but I will list a few things I know that annoys me here. I encourage those who are more knowledgeable about this particular tax system to comment.

1. It’s Another Set of Forms to Fill Out – I think this part annoys me the most. Filing taxes is already complicated enough, but it’s doubly as annoying when you have to fill out forms for a second set of tax rules. This second set of rules makes everything more confusing because you have to keep track which set of rules goes with with tax system. What’s more annoying is that I usually can’t determine whether or not I have to pay the AMT until I complete both forms.

2. You Can’t Deduct State and Local Taxes – In the regular tax system the taxes I already paid to California is a deduction and no federal tax is paid on the money, but in the AMT state and local taxes (including local real estate taxes) are disallowed as deductions. This means that you pay taxes on the money you already paid as taxes. That just doesn’t make sense to me. In high tax states like California it could mean paying hundreds to thousands of dollars more on money you didn’t receive in the first place.

3. It Is No Longer a Tax for the Rich — The legend goes that this second system of taxation was invented in 1969 to prevent 155 extremely rich individuals from paying very little or no taxes. Then it was never indexed for inflation so now almost 40 years later we’re still using 1969’s standard of “extremely rich” to determine who should pay this tax. That makes absolutely no sense to me. Also, the standard of “rich” is very different across the United States. Here in the Bay Area, a family of four making $75,000 to $100,000 a year is by no means fabulously rich because our cost of living is extremely high. Adding to our cost of living is our high state taxes that can’t be deducted. Exemptions on children also can’t be deducted so families with more kids would be more likely to thrown into AMT status. It is estimated that 50% of families making $75,000 to $100000 a year will be subject to the AMT, and it is just an additional financial burden on a lot of middle class families.

4. It Nullifies Most, If Not All Tax Cuts in the Original System — Whenever I try to explain this point I have people saying that I am a conspiracy theorist and that the government didn’t intend for the AMT to hit the middle class. But here are the facts, suppose you paid $3000 originally in federal taxes and your AMT calculation comes out to $2999, then you don’t have to pay the AMT because your tax amount in the original system is higher. However, suppose the Bush Tax Cuts cut your taxes in the original system down to $2400, then you scored $600 right? Nope! You still have to pay $2999 because the rules governing the AMT hasn’t changed and now the AMT is the larger amount. In cases like these the AMT pretty much nullifies the tax cut completely. I have known people who started to pay the AMT because the Bush tax cuts made their federal tax lower than the AMT, and basically these middle class families didn’t benefit very much at all from the “tax relief”. I actually think the Bush tax cuts are fiscally possible because of the AMT. As I mentioned in the previous point, the AMT isn’t indexed for inflation, so they know that more and more people will be thrown into AMT status every year, and that means collecting more revenues from this second system as time goes by.

Anyway, I will conclude my rant here. Here’s a funny thought: if the alternative minimum tax never gets indexed for inflation, eventually everyone will qualify, and it will no longer be “alternative” and nobody can say that it’s a tax for the rich because everyone will be paying it. Then the IRS can just print one form again and completely abolish the original tax system!

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My schoolmate Anna asked the following in a comment:

What is your stance on saving for retirement vs saving for house? I’ve been reading some advice that says only save for house first (putting into high-yield savings account) and save for retirement once you have a house. Other advice says always save 10% of gross income to retirement even when you’re saving for a house.

Well, first I have to say that everyone’s priorities are different, but my husband and I are saving for both. We are both contributing 17% of our income to our 401ks and we have gotten used to that deduction so we don’t miss the money at all. We don’t totally max out our 401k but 17% is a good amount that we’re both comfortable with. We’re keeping most of what we save outside of our 401ks in a Vanguard money market fund and a Vanguard index fund and we do intend to use the money to purchase a home sometime in the future.

Personally I think that saving for a house shouldn’t be put ahead of saving for retirement. The reason is that money grows exponentially in a retirement fund with time. Generally the earlier you start contributing the larger a nest egg you would have in the end. Diverting your money from a retirement fund to purchase a home would require much larger retirement contributions in the future to achieve the same nest egg. Lets use some real numbers to see what I mean.

Scenario 1: 24 Year Old Saving for Retirement for 35 Years

Suppose that I put $1200 a month into a 401k. Since this money is contributed pre-tax, I am actually seeing a deduction of about $800 from my paycheck due to my fairly high tax rate in California. I can withdraw from my 401k at the age of 59.5 without penalty, so I can keep on contributing for at least 35 years. Assuming a fairly conservative average annual growth rate of 7% a year, my nest egg will grow to approximately $1,990,611 at age 59.5. Meanwhile I can still save whatever money I have left for a home.

Scenario 2: 24 Year Old Saving for a Home Before Saving for Retirement

Suppose that I need a downpayment of $75,000 for a below median price Californian home and I am saving what I would have put into my 401k into a money market account. I would have to save after-tax money so I could only contribute about $800 per month and lets assume that I use a money market fund that pays 4% per year after tax. At this rate, it would take me just about seven years to save for the downpayment. The $75,000 is good for a 20% downpayment on a $375,000 home. Usually there are other closing costs so actually I need more money to buy a $375,000 home. Just to make this example simple, I will say that $75,000 is adequate for me to buy a $375,000 home and the entire $75k is applied to the price of the home. Suppose that I take a regular fixed 30 year loan on the remaining balance of $300,000 and I get a fairly good rate of 6% I would now have a mortgage payment of 1798.65 per month.

This scenario means that I would lose seven years on my retirement contributions. If I contribute $1200 a month to my retirement for only 28 years I would have only 1,599,377 at age 59.5.  To reach the same nest egg of scenario 1 at age 59.5, I would have to contribute about $2055 per month to my 401k for 28 years. This is not even possible without company matching because the IRS limit on 401k contributions is $15500 a year right now.

Now, some may argue that  savings are going into the home that I bought. Historically, home prices have only risen 2 to 4% over long periods of time. Additionally, there is a 1.1% property tax in California on the value of my home every year even if I have paid it off. In other states the property tax can be very high and completely wipe out the gains on a home. So, suppose that I take an extremely optimistic growth rate of 4% on my home then the home is worth about $1,216,274 after 30 years. However, I am not accounting for the effects of inflation and maintenance costs so I think I would break even at best.  If I put the mortgage money in an investment account instead I would have more than $2,000,000 after 30 years assuming a growth rate of 7%.  In that case, I could use my $2 million and buy a better house with cash.

With all of that said, I realize that not everyone live in a place with ridiculous real estate prices and in some places of the country it still makes sense to buy a home because the house payments are less than rents. In those less crazy parts of the country it doesn’t take seven years to save a reasonable downpayment so the potential time loss on a retirement account isn’t as severe. Saving for a home first could make sense for some people. However, it really would take young people years to save an adequate downpayment here in California. In fact, there is nothing decent for $375,000 here in San Mateo and a 20% downpayment on an average home is more likely to be $120000 to $140000. My stance on the subject is to save for retirement as much as you can and as soon as possible. You can still save for a home as much as you can, but you should clearly understand that a home is a cost center, and not a savings vehicle. I still want a house of my own, but I do not expect it to feed me and pay for my health insurance when I retire. I would approach buying a home as I would approach buying any other item, such as a car or a stick of gum. I want a quality home at a reasonable price, and I don’t mind waiting a while for a sale. While I wait to buy a home, I am building up a strong retirement nest egg. I hope I answered your question Anna!

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