3 Common Myths You Probably Believe About Taxes

February 04, 2019

One of the areas that I find to have the most misconceptions is taxes. After all, Einstein is quoted as saying that the hardest thing to understand is the income tax…and that’s when it was a lot simpler than it is now! Here are the biggest ones I’ve seen as a financial planner:

Myth 1: Your goal should be to minimize your taxes above all else.

No one likes to pay taxes, but making the goal solely about minimizing what you pay implies you should earn no income so you have no tax liability. More realistically, this idea comes up most frequently when people are reluctant to pay off their mortgages because they’ll lose the tax deduction

Reality: There are good reasons not to pay down your mortgage early, but the mortgage interest deduction isn’t one of them. While the mortgage interest deduction can reduce the cost of interest, it’s still a cost. The deduction simply makes mortgage debt cheaper than non-deductible debt with the same interest rate. Don’t let the tax tail wag the dog and instead focus on maximizing after-tax returns.

Myth 2: Your marginal tax rate is the percentage of your income that you pay in taxes.

In other words, if you’re in the 24% federal tax bracket the thought is often that it means you pay about 24% of your income in federal taxes. In my experience this is how most people think about tax rates.

Reality: You only owe the marginal tax rate on income in that bracket. So, you would only owe 24% on any income over that amount and the rest would be taxed at lower rates. This is why you’ll probably end up paying a lower average tax rate on your 401(k) withdrawals in retirement even if you retire in the same tax bracket. (Your contributions come off the top and avoid that marginal rate, while a lot of the withdrawals will be taxed at the lower rates.)

Myth 3: You need a tax accountant to take advantage of various loopholes to reduce your taxes.

This is probably one of the main reasons people hire tax preparers. It’s also true for anyone who doesn’t feel comfortable using tax software.

Reality: Tax accountants can be helpful if you own a business or investment property since many of the deductible expenses are ambiguous, but tax software should do the job for the average person. The reality is that most of what you can do to reduce your taxes is in the planning before the taxes are prepared. That mostly means contributing to tax-advantaged accounts like 401(k) plans, IRAs, and HSAs. A good financial advisor can also help you minimize taxes on your non-sheltered investments.