We all know two things are certain in life – Death and Taxes. Well, the first one we really can’t control, as it is going to happen eventually, but why pay more taxes than you need to? In Episode 2 of my Financial Health Series, we will discuss how you lose money by paying more taxes than you have to, and what you can do about it.
Gary Collins: Hi. This is Gary Collins, best selling author and the creator of www.thesimplelifenow.com. This is Episode Two of my Financial Health Series. I’m here again with Shawn Perkins with Principle Shield Financial Services. Thanks for coming on, Shawn. We’re going to talk about how you pay your taxes will cause you to lose money or gain money, depending on how you do it.
Shawn Perkins: Well, that is true. We talked in the first episode about different ways that people lose money. We mentioned that the mortgage, how to choose, structured and pay for their mortgage, is number one. Very close second if not even bigger than that is how they choose to pay their taxes.
What I mean by that, it’s often confusing when people hear me say that, is the IRS gives us choice and control as to how, when, or if we choose to pay taxes on our accounts. If we don’t understand that, then we do what everybody else does and that can end up costing us a fortune.
What I mean by that is, we invest money largely in accounts that are taxable at the time that you earn interest. You’re in a savings account, checking account, you’re in the stock market, mutual funds, those kinds of things.
Each year those institutions that you have your money send you an IRS 1098 form, which is telling you how much interest you earned that year and you report that interest on your taxes annually and you pay the interest.
Most people don’t feel the impact of that because it just simply decreases the amount of refund that you’re going to get if you are getting a refund, or it increases the amount that you have to pay if you write a check. Many times, we don’t take the taxes out of the account with which we earned the interest and we write that check for the taxes out of our lifestyle.
We pay for it from our checking account or it reduces the refund, so we don’t really feel the impact of it.
That’s the first way that we can pay taxes that we don’t otherwise need to pay by having our money in accounts that we pay taxes on as the interest is earned. Piggybacking on that is, most people, when they have money in savings accounts, CDs, checking accounts, or in the stock market or mutual funds, we allow whatever our gains are to reinvest into that account. We call that compound interest.
Compound interest is a wonderful thing in and of itself. But it can create another problem, as well, which is, increased taxes. Because now your interest is earning interest, which is good, that’s the compound interest part of it. But then now that makes your account grow at a faster pace, and because your money’s growing in a taxable account, your tax liability is increasing.
Most people would think, “Oh, I don’t mind. I’ll pay more tax if I’m earning more money.” But again, you will get to a point over time where the amount of tax that’s owed becomes very cost prohibitive, because if it’s coming out of your tax refund, eventually it will eat the whole refund up.
If it’s not coming out of a refund, but it’s more money that you have to pay when you file your taxes, that money has to come from somewhere. Not many people have that much money laying around to pay their tax bill. It can become a rather sizable problem because you’re not taking the money out of the account to pay the taxes.
It’s coming out of lifestyle. Those are two big ways that we lose money with how we choose to pay our taxes.
Gary: That’s very interesting. I’ve gotten out of all my investments. I still own some stocks, but I noticed a lot of investments are like double taxation, most of them, because you pay taxes on the money that you earn, and then if you invest it and you have a gain, a capital gain, you pay taxes on that gain again.
I’ve always thought that is such a crappy system. I’ve already paid taxes on that money. That’s my money, and if I make gains on it, I’ve already paid taxes. It would be as if I sold a car or bought my car. I pay taxes on it. Then when I go to sell it again I’ve got to pay taxes on it again. That’s how I look at it.
That’s why I’ve changed my investment strategy a lot. I’m no expert. I’ve handled my own finances, but I’m soon going to get out of that. You will be handling all that down the road when I have some more money, and I’m not building houses off the grid, and doing all kinds of stuff like that.
What would you say for a 401(k)? Would you still recommend that even though you pay the taxes up front, but on the withdrawals down the road when you hit, what is it? Is it 57? What’s the age?
Shawn: 59. That’s when you have access to the money without the early withdrawal penalty. Let’s talk about that. 401(k)s, that was the next area where people choose to pay their taxes. It can be harmful to them. 401(k)s and IRAs and other accounts like that, 457 plans, 403(b)s, they’re all under an umbrella called Qualified Plans.
Qualified with who, should be the question everybody’s asking. That’s qualified with the government. They’re great plans because they allow you to invest money pretax, prior to being taxed, into an account, and then they allow the growth that’s in that account to defer the taxes as well, and so the question is, to when?
You’ll pay the tax on that money when you withdraw it from the account. If you withdraw it from the account prior to 59, you’ll pay a 10 percent early withdrawal penalty. That’s a pretty stiff fine, if you will, for accessing your money prior to when the government wants you to.
Then when you pull the money out after 59, you’ll have to pay ordinary income tax on that, which is whatever your highest tax bracket is at the time that you withdraw the money. Everybody thinks, when they’re making investments, in terms of the immediate 12 to 24 months surrounding their lives, surrounding that decision.
What I mean by that is we believe the tax rates today are going to be the same tax rates 25 years from now. That may or may not be true. In fact, if I have the opportunity to show you a tax chart you would see quite readily that it’s not the case.
We’re actually in one of the lowest income tax environments that we’ve been in, in the last 50 years or more. I ask this question of people that are investing in tax‑deferred vehicles. I’ll ask you this right now, Gary. What do you believe the future of tax rates is going to be? Are they going to be higher than they are today?
Are they going to be lower than they are today? Are they going to be the same as they are today?
Gary: I would say the way the federal government works, and the way state and…I have no idea. [laughs] It’s pie in the sky. I couldn’t even begin to predict what our governments are going to do anymore, but if I had to throw a wild guess out there I would say it’s going to go up.
Shawn: When you were talking about that, I was going to say you know your gut is telling you that future tax rates will be higher. They’ll be higher for a very wide array of reasons, not the least of which is Social Security. We keep hearing everybody talking about Social Security.
We have the largest group of people, the baby boomers, retiring in our nation’s history. Right now we have 10,000 people a day retiring, baby boomers, and they’re all drawing Social Security. All of those folks that are drawing Social Security are also going on Medicare, and so Medicare is another thing that’s going to cost a lot of money as people grow older and go forward.
You have two wars with Iraq and Afghanistan that we just got through. Traditionally, when you look at our nation’s tax rates, anytime we’re involved in any kind of a war, police action, conflict of some kind, tax rates always increase because we have to pay for the war.
After 2001, 9/11, we couldn’t raise tax rates because out economy was in too fragile of a state to raise taxes, so what do we do? We put our wars on the credit card. That’s why we went from owing six trillion dollars in national debt, to know we’re at 18 trillion dollars in national debt, trillion with a “t,” not billion with a “b.”
Trillion, that’s a number that we had not heard prior to the last 10 to 15 years. Now, we’re seeing trillion dollar deficits every year. This year we’ve kind of curved that down a little bit, but it doesn’t change the fact that for however many years in a row, we’ve been on a trillion dollar deficits, which adds to the debt.
Taxes have to go up because where does the government generate revenue to pay our debts, to pay for our social programs? Taxes, that’s the only way they get money. They have to go up. How much are they going to go? It’s anybody’s guess, but it’s going to be fairly significant.
When you listen to comments from people like Nancy Pelosi say, “We wouldn’t have a problem anymore if taxes would return to historical levels.” Most people don’t understand what “historical levels” means. Historical levels has our average tax rate over the last 100 years that our taxes have been in place is 60 percent.
We’re at 39.6 in the highest bracket right now. That’s a significant increase. Tax‑deferred vehicles: When you pull money out of tax‑deferred vehicles in the future, you will pay the taxes at that higher tax rate when you could have otherwise paid the taxes today at what would arguably be your lowest tax rate.
That’s going to cause a lot of problems for people, and they’re not going to find out about it until it’s too late to do anything about it.
Gary: That’s very true. It’s tricky. I tell people when it gets into taxes…and I had it backwards. A 401(k) is tax deferred…
Shawn: I know what you mean.
Gary: And Roth is where you pay the taxes up front. You’re taking that money, and then you don’t pay taxes when you withdraw. I had it backwards. The best advice I got early on in life, as I’ve tried starting my small businesses in my late 20s, I want to say early 30s, was that, “always have a good accountant.” I will say that holds true.
I have saved a ton of money on paying taxes and what I owe, with a good account. I’m not rich by any stretch. I don’t have these tax shields and havens that I can use like Mitt Romney or someone. I don’t have that. I’m an average, everyday person.
There’s a lot of things that a trained professional accountant, a CPA, knows that the average lower end accountant, H&R Block, or something like that, doesn’t know. It’s especially true if you’re an entrepreneur and you have businesses. That’s where it gets tricky and understanding what is a write‑off, what isn’t, and keeping you out of trouble.
That’s another thing, too. I know people who run their own businesses who do their own taxes. I would not want that liability ever. Pay the money to have an accountant. I think that’s an important part of it, too, how you pay your taxes. Well, that professional’s going to tell you how you’re going to pay your taxes and take care of you.
When it gets into it, like I said, I consider myself a fairly smart guy. I’m not a rocket scientist by any stretch, but when it comes to taxes, understanding how they work, and investments, they’re tricky for a reason. The government wants to get as much money as they can out of you, bottom line.
Shawn: That points to something we’ll cover in the next episode, but the way the government writes the tax code is so that the average Joe can’t understand it. There’s a reason why because it generates additional tax revenue, fines, and penalties. I don’t want everybody to believe that we’re conspiracy theorists.
The point is we’ve been around a long time. We’ve seen enough of this to know that it’s true. When you’re on my side of the desk and you know the tax codes and you know the investments, you can tell the IRS has written them the way they’ve written them for a reason, or the government I should say.
Gary: They’re written by attorneys. I spent a good portion of my life working with attorneys, and I worked with the IRS. My investigations ran with the IRS were involved in my cases. Watching how it worked was mind‑boggling. They have to know so much, and they can never know it all. If they want to get you, they can get you.
The codes are written that way. That’s why I always tell people, “Don’t play around with your taxes. Don’t try and cut corners.”
Shawn: The last knock anybody wants on the door is from the IRS.
Gary: Trust me. I’ve had friends it’s happened to. I’ve had friends who own businesses it’s happened to, and it’s a nightmare. You can have whatever belief system in the government you want, but you better pay your taxes and do it right. That’s the whole thing where Mitt Romney got blasted and some of the other people, the Clinton’s, everyone.
It doesn’t matter what party, but they make so much money. The tax laws are written to their benefit more or less, and they have the ability to pay high‑end accountants and attorneys to get through the tax law and find all the loopholes.
We don’t, and that’s just a fact of life. I always tell people because they think, “Gary, you’re just wearing your tin hat. You’re on the brink of anarchy and all.” I’ll say, “No, no, no, no, no. There’s rules to be followed. I am not stupid.”
There are certain things you don’t want to mess with, and one of them’s taxes. You do not want to get yourself in trouble, but at the same time you want to be financially savvy and pay the least amount under the law that you have to.
Shawn: That’s the point that I want to make. You don’t have to be Mitt Romney or Warren Buffet to be able to take advantage of the existing tax code to your benefit. There are plenty of tax breaks for people in yours, mine, and our clients’ income strata that are available to them that allow them to take advantage of the code and save taxes.
You don’t have to have exotic vehicles like owning laundromats and all that kind of stuff to shelter your income. There are every‑day vehicles available. You mentioned one of them, Roth. A Roth IRA or a Roth 401K allows you to pay the tax on your money today and invest it in an account that grows tax‑deferred and comes out tax‑free.
That’s a wonderful vehicle that’s available to a lot of people today. Now there are phase‑outs in place for higher‑income individuals, but the point is that’s a vehicle that’s available to everyday Americans to pay taxes at what they believe today might be their lowest rate so they don’t have to pay them later at what could be a higher rate.
The problem is with a Roth IRA, for example, they limit your contribution to $5,500 a year. Well, if you put $5,500 a year away and you put it away ’til you retire, it’s not going to be enough for you to retire on. There’s a reason why the IRS limited the contribution to $5,500 a year because it’s such a wonderful way to save for your retirement.
Then you look at the Roth 401K, it doesn’t have the same limitation. It follows the same limitations as a regular 401K, but very, very few employers have implemented the use of a Roth 401K because it’s an administrative cost for them. It’s another nightmare because they have to run the parallel programs because you have to offer them both if you offer them the Roth 401K.
Those are ways that people can use to lower their taxes, and there are others. Back on ways that we cost ourselves money in the way we pay our taxes, we talked in the last episode on mortgages about people pre‑paying their mortgage. That’s one of the ways that people lose money, by pre‑paying their mortgage.
They see the front‑end benefit of reducing the interest that they pay, but the back side of that or the flip side of that coin is that when you reduce the interest that you pay to the lender you also reduce the tax reduction that you get for paying that interest. It increases your tax liability. It’s not a dollar‑for‑dollar increase. Nonetheless it is an increase in your taxes.
Gary: That’s a good point, and I’ve never heard anyone implement that difference into the life of the loan. If you were to pay it off early, what would you be losing long‑term in a tax write‑off, and what would be your net gain? I think that’s something I’ve never seen because it’s complicated.
It depends when you pay it off, how much interest you’ve already paid, and all that. It’s a moving target. I’ve gone through that one a million times in my head, too. That’s why I tell people to find someone like you. I’ve spent years trying to figure out my own finances and do it the best I can, and I’m lost half the time.
It is complicated. Getting in contact with a financial professional, someone who does this for a living, is definitely a good move. I know in the survivalist and self‑sufficiency communities I’m in, there are definite financial planners.
We all recommend them because there’s other things we would like to do instead of spending time trying to go through this maze and juggernaut of trying to figure out what is the right investment? What is the right timing? How should I pay my taxes? When should I pay my taxes? It goes on and on and on.
I think it’s just worth the peace of mind to know that you have a professional that you can trust. That’s what we work on, too. We go out and recruit people like you who we trust because there’s a lot of, just like anything else, scammers out there that will just rip you off.
That’s one of the benefits of our communities and what we do and what I believe in in the Primal Power Method. That is community in bringing in people that you can trust.
Shawn: Sure. The two final points that I’ll make in this area are, number one, what I call opportunity costs. That’s the other part of this tax equation. If you pay a dollar in taxes that you didn’t otherwise have to pay, you not only lost that dollar but you lost what that dollar would have earned and grown to had you not lost the dollar in the first place.
That sounds confusing. If you paid a dollar in taxes you didn’t have to pay, you lost that dollar. If you could have invested that dollar in an environment where you could make five percent, you lost a nickel as well. You didn’t just lose the dollar. You lost the dollar and the nickel. Now if you make that $100 or you make it $1,000, the example becomes more realistic.
I want you to understand that the opportunity costs that we’re talking about, you’re losing money in the ways that we’re talking about, but you’re also losing the interest that those monies could earn. That compounds to be a rather large number over a lifetime. That’s looking at one thing, like taxes, then looking at another thing, your mortgage, and looking at other different things.
All of them together turn out to be a rather large number. The last point is something called provisional income. Provisional income is another thing that people don’t understand. It’s an income that means that part of your Social Security will become taxable.
Right now, if you don’t make enough money and you get Social Security, you don’t pay any tax on your Social Security.
But income from an earned income, your job, income from a pension, income from IRAs and 401(k)s, interest on your investments, interests and dividends, those are all labeled as what’s called provisional income. When you’re collecting Social Security, the government looks at your provisional income and your Social Security and decides, based on those numbers, how much of your Social Security they’re going to tax.
If you have enough provisional income, you can have up to 85 percent of your Social Security benefits taxed, when they otherwise don’t have to be. That’s paying more taxes than what you have to pay. Now, you’re losing those tax dollars and what those tax dollars could become. Those are the last two big things I wanted to cover with you in the way of paying your taxes.
How you choose to pay your taxes can be detrimental to you. I hope it gets the point across, and we haven’t talked so fast that it becomes confusing. But, certainly, people can contact either one of us to go more in depth.
Gary: Let them know where they can contact you, Shawn, if they need or want your services and be able to talk to you.
Shawn: The blog, I write a lot about this. My last blog post was “Are Unintended Wealth Transfers Costing You a Fortune?” I do an example about prepaying your mortgage, not taking the savings, doing something else with it, and what it can turn into.
That’s at my blog, www.wiseandwealthyblog.com. People can reach me on my mobile number at area code 619‑994‑1110. They can go to my website at www.principalshield.com. Principal is spelled P‑R‑I‑N‑C‑I‑P‑A‑L. Then, of course, my email address, Shawn, S‑H‑A‑W‑N, @principalshield.com. Those are the four easiest ways to get in touch with me if people have questions or comments.
Gary: Everyone can get a hold of me at www.primalpowermethod.com, or contact at primalpowermethod.com. Thanks a lot, Shawn, for being on. I look forward to doing our next episode.
Shawn: Thank you for having me. This is a wonderful opportunity for both of us, I think, to reach people that we care about with information we feel is beneficial to them.
Gary: Absolutely. Thanks again.
Shawn: You bet.
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