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5 Tax Myths Debunked

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“Don’t let the tax tail wag the dog.”  In college, I heard that quote for the first time from the professor who made the greatest impact on me in those years, Dr. Daniel Singer.  He was—and is—that professor who unnerves students because he’s not predictable.  But it was his unpredictability, his passion and his depth of conviction that drew me to him, and I took as many of his classes as possible.  It is now my privilege to teach alongside Dr. Singer as an adjunct faculty member at my alma mater, Towson University.

If you’ve never heard the canine reference to taxes, hopefully the visual will stick with you and aid you in understanding the central tenet of this post—taxes, like a dog’s tail, are extremely important, but should not be the leading appendage, or factor, in most of your financial decisions.  Following, I’d like to expose the fallacy of five foremost tax myths and offer five rules I hope you will consider adopting.

Myth #1: “I Need a Mortgage for the Tax Deduction”

It is not a myth that most homeowners are able to deduct all or most of the interest they pay on a mortgage.  That is true, and the deduction has the impact of reducing our taxable income each year, and that is a good thing.  But, it is the pursuit of indebtedness for the primary purpose of having a tax deduction that is financial foolishness.  You’re effectively paying the bank a dollar to save a quarter!

Remember, you don’t get a deduction for your entire mortgage payment; it’s only the interest part of your payment.  So if you’re about to retire, only have 10 years left on your 30-year mortgage, and are advised to keep the mortgage because you’ll keep the deduction, recognize you’re not even getting much of a deduction at that point anyway.  You would be better served to pay the mortgage off, assuming you have the liquid cash, and be free from the payment in retirement.

You should never carry a mortgage for the primary purpose of having a tax deduction.

Myth #2: “I Can’t Sell This Stock—I’ll Have to Pay the Capital Gains Tax!”

Cisco, the beloved darling of the technology stock boom of the late 1990s, tells an interesting capital gain story:

Let’s say in October of 1998, you purchased 1,000 shares of Cisco for around $12,000.  You bragged over eggnog in December of 1999 how much of a stock-trading genius you were, sitting pretty with a Cisco position worth over $50,000, and your crotchety Uncle Pervis said, “That stock’s way overvalued!  You’d be stupid not to sell at least half of that stock now.”  You retorted, “That’s crazy!  I read in a magazine that ‘it’s different this time,’ and besides, I’d have a huge capital gain tax bill if I sold now.”  You called Uncle Pervis to rub it his face in March of 2000 as you were sitting on an $80,000 position, but Uncle Pervis would have the last laugh.  By September of 2001, your position was back where you started; down from $80,000 to your original investment of $12,000.  You no longer had to worry about capital gains tax because your gain had evaporated.

You should never hold an investment with the avoidance of taxes as the primary determinant.

Myth #3: “I’m Buying This Investment to Lower My Taxes

In the 1980s, limited partnerships were a red hot investment.  While they did have a bona fide investment component to them, they were sold largely on their seemingly magical ability to create a tax loss—and accompanying deduction—while the investment somehow made money.  A change for the worse regarding tax preference and the incredible illiquidity of these vehicles resulted in painful losses for investors who had been sold shares in limited partnerships.

Other investments that are often sold with tax preference as the pointy end of the sales pitch are annuities and municipal bonds.  Discussed in depth in my last post, annuities may offer as many tax disadvantages as advantages, and the tax-effectiveness of muni bonds depends largely on your tax bracket.  This is not to suggest that there are never appropriate uses for the above referenced investment vehicles—there certainly are—but you should never purchase an investment for the primary reason that it will benefit you from a tax perspective.

Myth #4: “The Bigger the Tax Refund, the Better!”

When winter begins to turn into spring, we all start thinking about taxes—or, at least, we should.  It is that time of year when we’d rather be receiving a check than writing one, but we are missing the point.  The point isn’t to give Uncle Sam a free loan so that we can feel an imaginary sense of surplus when we receive a refund; nor is the point to be so aggressive in our tax planning that we end up having to write a big check, or paying a penalty for having held on to too much of the U.S. government’s—I mean, our—income.

Neither should we judge our accountant on his or her performance by how much of a refund we receive.  Blindly following the accountant who offers the biggest refund can be a dangerous game.  I’ve had the displeasure of informing more than one client that their “awesome new accountant” won their business by committing tax fraud in their name.  And guess what?  Even if you use an accountant to prepare your taxes, you still sign on the dotted line and are responsible for any irregularities…and their corresponding penalties…and ignorance is not considered innocence…and there is no statute of limitations on fraud per the IRS.

The amount of a tax refund has absolutely no bearing on whether or not the taxes were optimally computed.  Take full advantage of the tax law and adjust your withholdings so you neither write nor receive a huge check at tax time.

Myth #5: “This Stuff Is Easy; Anyone Can Do It!”

Helpful software tools and low-cost tax preparation services leave the impression that tax planning can be done in a matter of minutes by people who have little or no training.  There is a major difference between tax preparation and tax planning.  The former can be done by a computer program or tax preparer, but the latter requires the help of a professional CPA working in tandem with you.

Your tax preparation software is only as good as the preparer, and don’t forget that our own Secretary of the Treasury, Tim Geithner, couldn’t get TurboTax to work properly!  Even if you think yours is a situation that is easy enough to be handled on your own, you should visit with a CPA every few years to ensure you’re not missing something significant.

Most people would be best served by having a professional Certified Public Accountant prepare their taxes. 

I’ve created an exercise designed to help you recognize the 5 Tax Myths in your financial plan, but first, click HERE to read about the 5 Tax Rules that are worthy of following.

Much of the material in this post was legally stolen from the book I co-authored with best-selling author, Jim Stovall, called The Ultimate Financial Plan: Balancing Money and Life, in which you’ll find more on this particular subject in Chapter Eleven: The Gift of Preparation.

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Follow me on Twitter @TimMaurer and read my Forbes blog here.