Why it pays to pay attention to taxes

Taxes are one of the best inventions in the history of human civilization. I may be the only person who thinks that, but without taxes, civilization would collapse. How else do we pay for our roads, emergency services, schools, hospitals and social programs?

Without taxes, the government doesn’t function. And without a functioning government, life begins to look like a Mad Max movie.

I’ll watch a post-apocalypse movie — but I don’t want to live in one.

With the understanding that taxes are good and essential to civilization, I concede they also destroy wealth. Taxes are a wood-rotting fungus on the tree of personal finance.

If you don’t pay attention to taxes, they will eat away at your income, savings and investment returns.

The median household income is around $70,000 in the U.S., and the effective median tax rate is around 30%. This figure includes federal and state taxes while ignoring sales taxes, property taxes or any other miscellaneous local taxes. State taxes vary, but this is a ballpark number we can play with.

A 30% tax rate on $70,000 is $21,000 per year. If you pay taxes for 60 years in total, that is $1,260,000 in lifetime tax payments.

Instead of giving your money to the government, pretend you invested $21,000 per year at a rate of 8.7% in a balanced portfolio for 60 years. How much would you have? The answer is $42,018,186.

Tax policy can be a dry topic until you realize what it does to your net worth. Wealthy people pay attention to taxes — it’s like a giant pay raise if you play the game well.

The truth is taxes are terrifying for most people, which is why half of Americans pay someone else to do their taxes for them — even when they don’t need to.

Here are a few tips to help you win the tax game.

◆ Always file your taxes. Do it by April 15 of each year, even if you don’t have the money to pay them. Not filing will always end badly. If you do owe back taxes, the IRS has programs that can help set up a payment plan while possibly reducing the amount owed.

◆ Never, ever lie on your taxes. If you make a mistake, you can face penalties and fines, but not jail. But if you lie, things get ugly. Al Capone went to prison — for tax fraud.

◆ Document everything. The hardest part about taxes is keeping good records and categorizing all expenses properly, so set up a few file folders and drop receipts into them throughout the year. The more you document, the more you can deduct.

As a rule, if you can’t document it, you shouldn’t claim it. Incorrectly claiming a deduction may get you a slap on the wrist with a fine and, only if egregious, into serious trouble.

Claiming a deduction you don’t deserve is fraud. That is a world of hurt. If you can’t afford a professional bookkeeper/accountant, then schedule an hour each week for bookkeeping. Don’t try to do it all during tax time, which is a nightmare inside a migraine.

◆ Don’t buy something you don’t need just for a tax deduction. Generally, a deduction costs more than it saves, especially a house. The home mortgage interest deduction is potentially huge if you itemize your taxes, but if that’s your main reason for purchasing a home, you probably shouldn’t.

◆ You can likely prepare your taxes yourself. If your situation is simple, then a good software program will do all the hard work for you. If you run your own business, have a zillion different deductions or just prefer the convenience, then a good tax preparer can be a lifesaver.

If you play the tax game well and play it fairly, you’ll be able to give yourself a hefty pay raise simply by keeping more of what you’ve earned.

Are you eager to do your taxes now?

Doug Lynam is a partner at LongView Asset Management in Santa Fe and a former Benedictine monk. He is the author of From Monk to Money Manager: A Former Monk’s Financial Guide to Becoming A Little Bit Wealthy — And Why That’s Okay. Contact him at douglas@longviewasset.com