Money Mommy

Stuff your mom should have taught you, but didn't…


Category: Taxes

Returns are lower in IRA’s and 401K’s, Right?

I recently had someone tell me that they couldn’t make as much money in their IRA or 401K as they could if they just left their investment dollars in a regular taxable account. Huh?

Typical investment places include bank accounts, stocks, bonds, mutual funds, ETF’s. Money saved and invested in these places can be your taxable funds, as well as IRA’s and 401K’s.

The simplest and safest place to put your money is in a bank CD. You will earn a pittance in interest, but your money will be safe. Both your taxable money and your IRA money will earn the same interest rate. At the end of the year, interest earned in your taxable account must be included in your yearly taxable income, but the interest in your IRA will not be taxed.

Likewise, you can purchase $300 worth of stock from Company X with either your taxable money or your IRA money.  Let’s say you picked a great stock and your money nearly doubled! You choose to take your profit and you sell Company X for $500.00.  You now owe taxes on $200.00 if this was in your regular account. That same $200 profit earned in the IRA will not be taxed.

401k’s work essentially the same way. Generally, there is a more limited investment choice of mutual funds for your 401K dollars which will make an exact comparison a little more difficult. The concept is the same. If a mutual fund goes up; every account that has invested in that fund will go up whether it is a 401K, IRA, or regular account.

Whatever investment you have in a taxable account will be taxed the year you receive that money. This includes dividends and interest that may be reinvested. Whatever investment you have in a Traditional IRA or 401K will not be taxed UNTIL you actually take funds out at retirement. If you have these funds in a ROTH IRA or Roth 401K, you may never pay taxes on them.

So to be clear – whether you invest in regular accounts, IRA’s, or 401K’s, your money will grow at the exact same rate. What changes will be the tax you pay.  But that is for a later blog.

On Flexible Spending – Medical Expenses

The concept of Flexible Spending Accounts (FSA’s) is so simple that people think there must be a catch.  There really isn’t. You budget what your expected annual out-of-pocket medical expenses will be.  Then, you request that amount of money be allocated to your FSA account.  Your salary will be reduced by that amount, so no income taxes will be due on that money.  Although your employer is deducting that amount over the full year, the entire amount will be available to you on January 1 (if that is the start of your plan year.) It is true that you will forfeit whatever you don’t spend, but this is not as much money as you might think.  Let’s examine these points more closer.

(In 2016, the most you can contribute to an FSA is $2,550.00 or approximately $49 per week.  For my examples, I will budget $520 towards medical expenses or $10 per week.)

Budgeting for medical expenses. Let’s assume you visit the dentist twice a year for cleanings ($200), are anticipating four “well baby” visits ($140), and plan on buying new glasses ($180).  Opening a medical FSA for $520 will give you immediate access to those funds on January 1, even though you have budgeted $10.00 per week. You could choose to purchase your new glasses immediately or wait. This will give you some additional flexibility. Because, even though you have regular cleanings, you might also have an expensive cavity. In that case you could choose to put off buying glasses until next year and use the funds available in your FSA account for the unexpected dental bill. Glasses could still be purchased towards the end of the year if funds remain in your FSA account; or they could be put off another year.  You are in control.

Immediate access to budgeted funds.  If you anticipate a major medical expense, FSA accounts will allow you to accumulate the necessary funds immediately and painlessly.  A good friend informed me she needed new dentures.  She anticipated that she would need to wait six months before she saved the $520 needed for a down payment. Luckily her employer  offered FSA plans, and they were still in the open enrollment period. My friend immediately signed up for the FSA plan.  The full amount was made available to her on January 1, and she was able to schedule a dentist appointment for January 10. Her employer reduced her wages by only $10 per week.

Deducting medical expenses from your taxes. Yes, medical expenses are deductible on Schedule A of your tax form.  But for most individuals, these deductions will not affect your taxes.  You can read why on my new blog.  So, the only way to get a federal tax break for most individuals is by using Pretax Dollars from an FSA or HSA account. (But we are focusing on FSA accounts in this blog.)

Tax Savings! I just mentioned saving on your federal taxes. Most Americans are in the 10% or 15% tax bracket. This means of the $520 that we placed in our FSA example, most Americans would save $52 or $78.  Not bad.  But there are more tax savings.  Since the $520 was not included in their wages, there will not be any social security or medicare taxes; additional tax savings of $39. Nor will there be any state or local tax owed on the $520. State tax brackets range from 3% to 13%, so let’s use the middle,  8%, for illustration purposes.  In this case the state tax saved would be $41.  So, we have $520 available in our FSA.  However, we have reduced our overall taxes by at least $132.

Use It or Lose It.  This is true.  If you don’t use the full $520 during the plan year, you will lose the remaining dollars in your account.  I have had people who were wary of opening an FSA because they didn’t want to lose any of their money.  If they choose not to use the $520, they will pay the taxes of $132. This means that only a portion of that $520 actually ends up in their pocket.  In fact, in order to break even in their FSA account they would only need to spend the difference of $388 ($520 – $132.)  The rest would have gone to pay taxes. But since the entire amount was placed in the FSA account, they actually have a free bonus of $132 to use.  Remember, FSA accounts can be used for  dental work, glasses,  diabetes testing supplies, hearing aids and batteries, contact lenses and a myriad of other items as well as medical copays and prescription drugs. So if you find yourself with additional funds at the end of the year, consider purchasing some of these items.

But I’m Healthy and Have Great Insurance.  I have met a few people who are indeed blessed with great health and have equally great insurance with little to no copays, and therefor no medical expenses.  If you are in that enviable position, an FSA might not be for you.  Just know that it is there should the need every arise.  Meanwhile I’m putting in my $520 and saving at least 25% in taxes.

529’s? Forget it!

I have to just come out and say it….Do Not Open a 529 college fund for your kid!

A quick “google” of 529’s will give you a plethora of sites singing the praises of the 529 college fund. The concept is really simple.  Start saving early.  Your money will grow tax free.  When you take it out to pay higher education expenses, none of the money will be taxed.  Your child will walk debt-free  across the stage at commencement.

Unfortunately, life is just not that simple. And unless you have a crystal ball, the 529 is not necessarily a good thing.

Suppose your child is incredibly talented and leaps right from high school to a music or acting career.  Or perhaps they are athletic and head right into the big league.  No college for them.  You cannot touch the money you had saved in a 529 without incurring penalties and taxes.   Imagine how disheartening it would be if your child decided to live in your basement and play video games.  You would be even more discouraged about that 529.

Our friend’s son went right from high school into the marines. They certainly were proud of him.  They had also dutifully saved for his college education in a 529 account.  They can’t touch that money without triggering penalties and taxes unless they use it for education.  Their only child is making a career of the military and does not expect to need it for his education.  The only option is to give the 529 money to a distant relative or bite the bullet and pay the taxes and penalty.  Neither choice is very appealing.

But suppose you have a student who is following the traditional path of high school to college to career.  Aren’t you glad you started that 529 for them now!  Not so fast. Nearly all students will fill out the Fafsa, and your child’s financial aid will be negatively impacted by your prudent college savings.

The Fafsa is the Free application for federal student aid form.  By submitting the Fafsa form you will be told your “expected family contribution” or EFC to pay for college.  This will determine the federal grants and loans that your student is eligible for.  The Fafsa form is incredibly detailed, requesting information from  the parents’ and the child’s tax forms, their savings, investments, wages, property, partnerships, 529 savings etc. Parents are currently expected to contribute 5.64% of their assets towards the EFC; students contribute 20%.  The bite is harder on earning; Fafsa uses 22 – 47% of the parents’ earnings and 50% of the student’s income to calculate the EFC. Put another way, nearly  everything you have saved and everything you earn can be used to reduce your student’s federal grants and loans.  (There are a few exceptions such as retirement accounts and the family home.  You’ll find out how to use these to your advantage in this blog entry. – MoneyMommy)

Okay, despite everything I said, you still want to save in a 529 account. You’ve heard this is the best option, and I haven’t managed to convince you otherwise. While I commend your due diligence, let’s see what happens to your taxes now that your child is in college.  There are awesome education credits that can reduce your taxes by $2,500 for up to four years. That is a savings of $10,000! After four years, the Lifetime Learning Credit can generated up to $2,000 more for continued higher education each year.  Wonderful!  Except for one small problem.  You used a 529 account to pay his college expenses.  The government does not allow double dipping when completing your taxes.  You will not receive these education credits for any expenses that were paid for with 529 funds.  Your diligence just cost you $10,000 in higher taxes.

So, unless you are quite well off and are maxing out all of your retirement accounts, have lots of spare change, don’t expect to receive any financial aid, and won’t qualify for any education credits, do not start a 529 account! 

On Deductions and Taxes

People are so full of good advice – Especially when it comes to your taxes.

Do you want a new car?  “The sales tax on your new car is deductible.”

Feeling philanthropic? “Your donation is tax deductible.”

Need new doors or windows? “You can get a nice energy credit.”

Feeling bad about all those loosing lottery ticket? “My neighbor deducted all of his losing tickets.”

Student loans? “Big deal. The interest is tax deductible”

And so it goes with medical bills, mileage, home mortgages…so many things can reduce your taxes! You should spend! spend! spend!

It all sounds great.  Until you do your taxes, and you find that not much has changed.  So what happened to that awesome refund you were promised.

Lots of things.

Let’s look at the actual reason for doing your taxes every year.  Our United States tax is a “pay-as-you-go” system.  We are expected to pay our taxes on income as we earn it.  This is why our employer withholds taxes every pay day.  Individuals who are self-employed are expected to make estimated payments every quarter as well.  Then, by April of the following year, we look at all our income and determine how much we should have actually paid.  Did we pay too much? – We get a refund.  Did we pay too little? – We owe taxes.

Now, to complicate matters, the United States government offers incentives to encourage their citizens to act “responsibly.”  The government also reduces taxes to provide much needed relief in specific circumstances.

But let’s go back to that stack of deductions.

If you haven’t paid any taxes to the IRS, you won’t get a refund.  By the very definition of the word, refund, you are getting back what you have already paid in.  So, if you haven’t paid in any taxes you won’t get any money back.  Refund is money that you already paid in.

My sister-in-law plans to retire next year.  Due to the nuances of the tax system, she will not owe any taxes next year. She will not be required to file.  She will she not get a refund. In fact, she won’t have paid any taxes at all.  “But what about all my medical bills? Can’t I deduct them?,” she asked me.  The answer is yes and no.  Yes, you can keep track of all your deductions, fill out a tax form and send it off to the IRS.  But, no, you won’t get any refund since you never paid any taxes in the first place. In fact, your income is below the filing threshold so the IRS doesn’t even require that you fill out a tax return.  So what is the point of filing?

(Just to be clear, there are a few certain times that you can get money back that you hadn’t actually paid in, generally when there are children involved.  These are credits.  Some of them are refundable. We will discuss that in another post.  -MoneyMommy)

Perhaps you did have a job and you did pay taxes. Good for you! Currently, nearly every American citizen can reduce their gross income by over $10,000.00 to get to their taxable income.  If your taxable income is decreased to zero or below, you should not owe any taxes.  In fact you should get a full refund of your federal taxes that were withheld throughout the year.  More deductions will not cause you to get a bigger refund when you are already getting everything back.

The standard deduction is a gift to the American populace. Nearly every taxpayer can take the standard deduction, currently $6,200 for a single person, off their taxable income.   If all your deductions do not exceed the standard deduction, it is pointless to itemize your deductions. For instance, my neighbor has paid off his home.  His property taxes are just $525 and he donates $300 to his favorite charities, for total deductions of $825.  He can reduce his taxable income by $825 or he can use the delightful standard deduction and reduce his taxable income by $6,200. It’s a no-brainer.  He’ll reduce his income by the full $6,200, and save at least $620 on his taxes, if he’s in the ten percent tax bracket. AND he did not have to spend any of the $6,200 in the first place. Married couples can take double that amount ($12,400!) off their taxable income.  So, if your deductions are not even close to the standard deduction, all those papers that state “may be tax deductible” will not affect your refund at all.

But, beware! higher earners may run afoul of the dreaded AMT tax.  The AMT is a parallel tax system established in 1969.  The AMT tax is designed to ensure that everyone pays their fair share of taxes by eliminating many deductions. I’ll save that topic for another day.

To recap, deductions can certainly increase your refund by reducing your taxable income.  But it is certainly not a one-size-fits-all.  You need to examine your own circumstances to see what course of action is best for you.  When in doubt, talk to a tax professional.  And don’t rely on hearsay from your neighbor down the street.  Chances are, he’s about to be audited for deducting all those losing lottery tickets.


“What do you mean, I gotta pay taxes!!?” I’m a contractor!

Congratulations!  You are finally done with school and have entered the work place.


And your nice boss has hired you on as a contract worker!

He says you won’t have any taxes taken out of your paycheck.

And you get to take lots and lots of deductions.

Things couldn’t be better…Until you sit down to do your taxes in early April….That’s when reality hits.

You can’t deduct a home office when you actually work somewhere else.  You can’t deduct your gas and mileage and tolls when you drive to work – that’s called commuting.  In fact, your nice boss provides you with your tools, office supplies, work station. Everything.  You actually don’t have any deductions at all.

It’s about this moment in the tax preparation process that people start moaning that they don’t pay for more work items out of their own pocket.  Don’t fall into this trap!  Remember, everytime you haven’t had to pay for anything, you kept more money in your own pocket.

But I digress.  Anyone who is a contract worker must save for the April 15th reckoning with the tax man.  The contract worker pays his own federal tax, social security tax, medicare tax, state tax, and any additional tax imposed by his locality.  These are all the taxes that an employer would generally have withheld from his employee’s paycheck.  In addition, the contract worker will also pay the employer’s share of the social security tax and medicare tax.

So, as a rule of thumb, the contract worker should save a minimum of 35% of every pay check they receive:

  • 10% – 25% Federal Tax
  • 6.2% Social Security
  • 1.45% Medicare Tax
  • 5% – 7% State and Local Taxes
  • 6.2% Employer portion of Social Security Tax
  • 1.45% Employer portion of Medicare Tax
  • 30.3% – 47.3% Total taxes to save

Well, looking at the above taxes, perhaps the higher earning contract worker should aim to save closer to 50% of their check.

Both my daughter and daughter-in-law were hired as contract workers before they were actually permanently hired as employees at their respective firms.  I can still hear my daughter wailing, “You mean I have to pay taxes on all that money!?”  Well, sure.  So does the rest of the country.

Open a seperate account in your bank, and label it your tax account.  Put 35% – 50% of every paycheck you receive into it.  Without fail.  If you doubt this amount, recheck my numbers above, or find a friend or family member who is working and will let you look at their paystub; take a look at the taxes that are withheld.  You will see that taxes have reduced their check by nearly one quarter to one third.  And don’t forget you will need to double the social security tax and the medicare tax, since your nice boss is not paying for that.  You will need to save at least one third of your earnings.

Mark down how much is in your tax account on December 31.  Now figure out your taxes.  Do you have enough in your tax account as of December 31 to pay the taxes?  Good for you!  If not, you will want to increase the amount of each check that you save.  Anything extra is yours to do as you want.

And my daughter and my daughter-in-law?  They both saved 35% of their checks.  My daughter-in-law  had just enough to pay her taxes on April 15 and was delighted it had worked so well.  My daughter, who earned much less and had a much lower federal tax rate, had enough left in her tax account as of December 31 to take a once in a life time trip to Jamaica. She ziplined through the tropical forest that spring.