Monday, April 4, 2011

An Interesting But Flawed Tax Strategy

The Wall Street Journal has an article describing a scenario by which a person making $150,000 can pay no taxes legally and legitimately.  With the help of Gil Charney, principal tax researcher with H&R Block's Tax Institute, the WSJ's Brett Arends outlines one possible strategy for owing no taxes.  Not surprisingly, their strategy involves exploiting various tax deductions that are available to the self-employed.  However, is their scenario really feasible?  Let's take a look.

Before I pick apart their work, I first want to review exactly what a tax deduction and a tax credit are.  A tax deduction is money which is excluded from your taxable income.  If your income is, say, $50,000, and you have a tax deduction of $5,000, that means that $15,000 is deducted from your income for tax purposes.  Stated more simply, you only have to by taxes on $45,000.

A tax credit is money that is deducted right from your tax bill.  Let's say that in the above example, you owed $7,500 on the $45,000 of income you earned.  If you had a tax credit of $5,000, then instead of owing $7,500, you would only owe $2,500.  As you can see, a tax credit is more valuable than a tax deduction because your entire tax bill is reduced by the amount of the credit.

The Government doesn't give out a lot of tax deductions and tax credits for free.  Usually, you have to spend your money in a certain way.  The deduction or credit is an incentive which politicians give taxpayers in order to act in a way which they perceive as being beneficial to society (or to their chances of re-election).  For instance, in order to encourage people to buy homes, the Government allows homeowners to deduct the interest on their mortgage loans from their income.  The amount you pay in interest is deducted from your income from tax purposes.  However, you still have to write that check to the mortgage company, so you aren't getting the deduction for free.

Now that we have reviewed tax deductions and credits, let's get back to the article.  Mr. Charney of the Tax Institutes describes a scenario by which you can eliminate your tax bill.  However, doing so requires that you spend your money in a certain way.  Let's see how much money you have left over for everything else.  First, let's start with the deductions:

Item #DescriptionAmount DeductedAmount You Have To Spend To Get the Deduction
1Business Startup Costs$7,000.00 $7,000.00
2Business Expenses$10,000.00 $10,000.00
3Social Security, Medicare$9,500.00 $19,000.00
4Solo 401k$43,100.00 $43,100.00
5IRA (Self and Spouse)$10,000.00 $10,000.00
6State and Local Taxes$10,000.00 $10,000.00
7Mortgage Interest$10,000.00 $12,500.00
8Health Insurance Premiums$10,000.00 $10,000.00
9Health Savings Account$6,150.00 $6,150.00
10Student Loan Interest$2,500.00 $7,500.00
11College Tuition$4,000.00 $4,000.00
12Personal Exemptions$10,950.00 $-
TOTAL$133,200.00 $139,250.00

According to my calculations, in order to get $133,200 of deductions, you will need to spend $139,250.  Some explanation of my assumptions are in order:

Item #3:  Social Security, Medicare.  When you are self-employed, you still have to contribute towards Social Security and Medicare, just like you would have to do if you were an employee.  However, you only get to deduct half of your payments.  In other words, $19,000 in payments only earns you a $9,500 deduction.

Item #7:  Mortgage Interest.  I am assuming that only 80% of your mortgage payment is interest.  The other 20% is principal.  Unfortunately, principal isn't deductible but you still have to pay it if you have a conventional mortgage.  Nowadays, there are very few banks that will give you a interest-only mortgage.

Item #10:  Student Loan Interest.  Just like with a mortgage, only a fraction of your student loan payments will consist of interest.  Because a student loan usually is shorter than a mortgage, I am assuming that only 25% of your payment is going to be interest.

Item #11:  College Tuition.  For this item, I gave Mr. Charney the benefit of the doubt and assumed that your child's total tuition is only $4,000.  Therefore, you only have to spend $4,000 to get a $4,000 deduction.  However, in practice, you'll probably have to spend a lot more than $4,000 a year on tuition.

Based upon my calculations, these deductions will reduce your taxable income to a hair under $17,000.  However, if you pursue this strategy, you will have only $10,750 left over for other spending.

Of course, we aren't quite done yet.  The article states that with a taxable income of $16,800, you will owe Uncle Sam about $1,700 in taxes.  Now you could just pay the bill and then you'd be left with a mere $9,050 for the rest of your expenses.  However, the article attempts to reduce your tax bill to $0 through a couple of tax credits:  the home energy efficiency tax credit and the adult-education tax credit.

The home energy tax credit allows you to get a credit for 30% of qualified energy-saving costs up to $1,500.  In order to get the full tax credit of $1,500, you will have to spend $5,000.  That leaves you with $5,750 for other spending.

Next is the adult-education tax credit.  This allows you to get a credit for 20% of qualified educational expenses up to $2,000.  If you spend $1,000 on this training, you will get a credit of $200 which brings your tax bill to $0 as promised.  However, now you have only $3,750 left for other spending.

The article concludes with caveat that this is just an illustration ("Few will be quite so fortunate.")  However, based on the numbers, this strategy is doomed to fail.  Yes, your health care, mortgage, education, and retirement are all full paid for.  However, with only $312.50 a month for food, transportation, clothes, home repair expenses and the like, you will be in big trouble.

All that being said, this article is still very thought provoking.  There are two lessons to be taken.  First is that the Government provides all sorts of incentives to direct our spending in a variety of different ways, with a variety of different side effects.  Certainly, there are opportunities to game the system in order to reduce your tax burden.  The second lesson is that it really isn't worth it to reduce your taxes by a dollar if you have to spend more than a dollar to get that reduction.  Sometimes it is cheaper in the long run to pay the piper!

1 comment:

  1. It is an interesting planning strategy but at the time of paying tax we need such financial planner training and a good certified financial planner. Exchanging tax strategy and the amount you pay in interest is deducted from your income from tax purposes. Sometimes its good but tax paying to government is like "why we are?" Nice blog..