One of the biggest headlines during the Presidential campaign was about “lowering taxes” on individuals and corporations, and simplifying the tax code. A big argument for this is basically how complex the tax code is. Depending on who you ask, the tax code itself ranges from 2,600 pages long, to over 70,000 pages long. The discrepancy is all about whether you consider many of the addendum and prefaces as part of the actual “tax code”.
But talking about the “tax code” is hard. It's complex. And when it comes to campaigning, Presidential candidates don't like that. They like to stick to the bite size nuggets that can be shared on social media and talked about in less than 30 seconds on the evening news. That's why everyone focuses on income tax rates.
Heck, nobody even seemed to notice that Donald Trump's tax plan actually raises the tax rate by 5% on certain members of the middle class! But to figure that out, you'd really have to dive into the weeds and see what changes are being proposed. Instead, everyone likes to focus on phrases like this:
Let's lower the income tax rates on corporations.
Let's lower the income tax rates on the middle class.
Let's raise the income tax rates on the top 1%.
That's the headline you hear, and honestly, your income tax rate doesn't really matter that much.
Why The Tax Code Is So Complex
The tax code is so complex because it has to do four things:
- Define what income actually is
- Determine whether that income is taxable or not
- Define when that taxable income should be treated as such for tax filing purposes
- Run government incentive programs
Whoa, what? The tax code doesn't really talk about taxes?
That's right! The tax code itself dedicates about 5-10 pages to what the Federal income tax rates actually are for different types of income. The rest of the tax code is dedicated to defining what actually counts as income and running incentive programs.
That's weird? Income is income – isn't it?
Let's look at three scenarios that show how this can get complicated without even trying.
1. Define income – are your credit card rewards considered income?
It can get really confusing defining income. What counts and what doesn't. Let's say you earn 2% cash back rewards on your credit card, and you spent $1o,000. You would have received $200. Now, is that considered income, or a rebate?
In one camp, it's considered income – that $200 is marketing paid for by the credit card company. Heck, in many cases it doesn't offset any purchases, as you can have it deposited into a bank account.
In another camp, it's considered a rebate – that $200 is a discount from the $10,000 in purchases you made.
And it's not an easy answer. The answer is “maybe”. Here's a breakdown to consider if your credit card rewards are taxable.
It's questions like this that make the tax code so long. You have to have a discussion about every little nuance of income, if you're considering taxing it.
Here's some other common “define income” situations you might not have realized:
- If you get your student loan debt discharged, it could be taxable income even though you didn't receive any money directly.
- If you short sell your home, the amount of mortgage debt written off is considered income
- If you reinvest your dividends in a taxable account, those dividends are still considered income even though you never removed them from the account
2. Is your income taxable – let's talk about your IRA?
Okay, so once you define what counts as income, we have to have a system in place to determine if you're going to pay taxes on that income or not.
Your IRA is a perfect example. If you have a Roth IRA, typically your distributions will be tax free. However, there are some circumstances where it will be taxable.
All of these rules have to be laid out somewhere. That's where the tax code comes into play, and why it can get so complex. Once again, you need to look at every situation, and create a rule or formula to assess the taxability of each type of income you've defined.
3. When do you treat income as income – Let's talk about your small business?
Finally, the tax code has a framework for when you treat income as income for your taxes. This really comes into play with businesses and how they account for their income.
There are two main accounting frameworks – cash based and accrual based. Cash based means you account for your income when you get the cash. Accrual based means you count the income when you bill the invoice. This system also means that you might not get paid in cash for that invoice for 30 days. But you're already claiming the income. It can make a difference in your taxes.
Then there are also ways to count inventory that can dramatically impact your income. You can account for inventory as First-In-First-Out, or Last-In-First-Out. If the cost of your goods changes consistently, this could have a serious impact to your profitability and the taxes you'll pay.
All of this has to be defined by the tax code.
Let's Talk About Government Incentive Programs
You might not realize this, but the other goal of the tax system is to create incentives for people to do certain things. I bucket these as incentive programs, but most people call them tax credits and tax deductions.
The main reason that tax credits and tax deductions exist is because the government wants it's citizens to do something, or is trying to help with something.
For example, the mortgage interest deduction is supposed to encourage home ownership. The student loan interest deduction is supposed to make higher education more affordable. The penalty for not signing up for healthcare is supposed to encourage people to buy a qualifying health care plan.
Regardless of your personal beliefs around any of these issues, the fact is, they are administered through the tax code. As such, there has to be sections dedicated to each of these tax credits and tax deductions.
But it doesn't stop there. You also have to go back to the above section and include each of those parts for each tax deduction or credit:
- Define income – what income counts towards the tax credit or deduction
- Define taxability – some tax credits can give you a refund beyond what you paid in taxes
- When does the income count – some deductions can be carried forward from past years if they weren't all used up
So, now you can see why the tax code is so long – there is a lot of stuff to define.
Why Your Income Tax Rate And Bracket Doesn't Matter
Now that we've laid out exactly how the tax code works, you can see why your income tax rate and tax bracket don't really matter. What really matters is how you define your income, and what government incentive programs you're taking advantage of.
For example, another blogger shares how he only paid $150 in taxes on $150,000 in income. How did he do it? By taking advantage of all of the government incentive programs he qualified for:
- Retirement plan contributions (401k, 457 or 403b plans)
- Pension contributions
- Employee Stock Purchase Plans
- Employee Stock Ownership Plans
- Health Insurance
- Dental Insurance
- Flexible Spending Accounts (for health/dental or child care)
- Health Savings Account
- Mortgage Interest Deduction
- Student Loan Interest Deduction
- Child Care Tax Credit
- Child Tax Credit
On the flip side, as you build multiple income streams, you can start to diversify your sources of income and potentially start taking advantage of source of income that are tax-free.
How You Can Plan To Benefit From A Complex Tax Code
Despite every politicians promise to simplify things and lower taxes, I can tell you two truths about the tax code:
- It will keep getting longer and more complex, because you will continue to have to define what income means for new ways to earn that we can't even foresee yet
- The government will continue to use the tax code to incentive people, so we will still see various tax credits and deductions going forward
** I will note that with Trump and a Republican Congress, there are actual proposals to simplify the tax code. There is a lot to them, but they all involve changing rates and also changing deductions/incentives. Here is the best breakdown we can find to date about potential changes in 2017 and beyond.
Sorry, there really is no way for the government to implement any kind of flat tax system. But that doesn't mean you can't benefit from this.
The tax code can really work in your favor if you tax advantage of it. Some ways that you can leverage it to build wealth include:
- Saving in tax-advantaged accounts, such as an IRA, 401k, HSA, and more
- Invest in assets that are treated favorably tax-wise, such as real estate investing
- Start a side business so that you can leverage specialty savings accounts like a SEP IRA or Solo 401k to boost your tax-advantaged savings even further
- Ensure that you're taking advantage of all tax credits and deductions that you qualify for (use one of the major tax software providers too ensure that you're getting everything you're entitled to)
It's important to remember that taxes are likely one of your biggest expenses (check it – I bet you didn't realize it). As such, it's important to learn about how the tax code works, and take advantage of it so that you can save where possible.
How are you benefiting from a complex tax code?