Most people do not do their own taxes. They throw up their hands, decide it's too complicated, and go to an accountant or visit H&R Block or Jackson Hewitt. A lot of people also use electronic services such as TurboTax. This is kind of like doing it yourself, but the electronic process does hide some details of the tax system and how it affects you.
I usually do my own taxes, except for a couple of years when I tiptoed into an accountant's office and found out they don't necessarily do a better job, and they charge you a pretty penny for the service. I have also used TurboTax, but find that it doesn't always make life easier.
While it does take some time, and the process is not entirely painless, doing your own taxes can be an educational experience. I'm not talking about practicing your arithmetic skills. I mean you find out what the government encourages you to do, and what it penalizes. In short, you find out how the world really works. Here are ten lessons I learned doing my own taxes over the last couple of weeks:
1. The federal tax system penalizes working. Not only do you pay the highest rates on the income you earn by working, but you also pay a Social Security and Medicare payroll tax of about 7 percent. (Last year it was a little less because of the payroll tax holiday.) To add insult to injury, the IRS has gotten rid of the "making work pay" provision which allowed you to deduct up to $400 from your tax bill if you had earned income.
2. The federal government wants you to invest in the stock market. Some of the money you make from capital gains—the profit from selling a stock for more than you bought it for —doesn't get taxed at all. The rest is taxed at a lower rate than the money you make on the job. A lot of dividends are taxed at a lower rate as well.
3. Investing in bonds or savings accounts is not encouraged. The interest rate you receive from a short-term bond or regular savings account is the lowest it's been in decades. It's below the rate of inflation, which means you are actually losing money. The IRS doesn't care. It taxes the little bit of interest you earn at its regular rate, meaning you lose even more money.
4. The government can't make up its mind about real estate. Real estate investors can take advantage of certain tax breaks, such as depreciation, but are excluded from others. Rental income is taxed at the full rate, as opposed to stock dividends, which get preferential treatment. Bottom line: Investing in real estate can be a good deal, but it's not for everyone.
5. Owning a business brings special tax breaks and extra paperwork. Again, many tax breaks are available to people who work for themselves, from generous mileage allowances to deductions for travel and entertainment. But there are drawbacks as well. For one, you have to pay both the employer's and the employee's part of the Social Security tax. And the tax-filing process can be confusing and complicated, requiring obsessive record keeping and mind-numbing calculations.
6. The IRS does want you to save for retirement. The government offers a wide and complicated array of vehicles to save for retirement, including the IRA, Roth IRA, SEP IRA, and 401(k) plan. These accounts allow you to pre-pay or defer the taxes you have to pay on your savings.
7. It’s more tax efficient to get health insurance through your business than on your own. The IRS allows you to deduct health insurance premiums if you get medical insurance in the workplace or through your business. But if you buy medical insurance on your own, there is no tax break for you.
8. The government will cut you a tax break if you're sick. You can deduct out-of-pocket medical expenses that exceed 7.5 percent of your income.
9. Going to college is encouraged. There are several ways to deduct a portion of college tuition on your federal tax form, and many states offer tax breaks for educational expenses as well. The 529 college savings plan is a relatively simple and easy way to avoid taxes on money you put aside for college.
10. It’s difficult to do your own taxes. The federal tax code reportedly runs for some 13,000 pages, and details all kinds of rules, regulations, breaks, and penalties. Plus, there are many more pages at the state level. And if you ever get audited, the government will want to inspect all your records and backup materials. The whole process is way too complicated for the average person. The IRS really wants you to go to an expert who will correctly determine your payment and file it electronically.
Tom Sightings is a former publishing executive who was eased into early retirement in his mid-50s. He lives in the New York area and blogs at Sightings at 60, where he covers health, finance, retirement, and other concerns of baby boomers who realize that somehow they have grown up.