[I updated an earlier post on IRAs to mention one of the most important characteristics of Roth IRAs – early withdrawal of contributions without penalties or taxes].
Almost all Americans should do their taxes themselves. Many people just have wage income and some bank interest, which is incredibly simple to file. Some people all capital gains and qualified dividends to that, which isn’t that much harder. A couple of tax credits can get hairy, but for the most part, people should do their taxes themselves, by hand, without any software. Now I do recommend using software to check your work (so long as you can find free software that will handle your tax situation). But you should do it by yourself by hand first. I have two major reasons for this recommendation
- If you just mindless answer the questions asked by tax software, you don’t learn the tax code, which means you can’t plan ahead
- You can outsmart the tax software and get a better refund. I’ve done this before, and will continue to do this for every single year I am a graduate student.
You should learn the tax code
When you just answer questions in tax software, you’re not learning how taxes work. Now granted, I like to think i’ve given a pretty good overview on taxes. But there will always be things that I don’t cover. And, I may have explained things incorrectly – I am by no means a professional.
This means you can’t plan ahead. For example, take hypothetical Janice. She gets paid $78,000 a year. The first year she started working, she started in July. Hence, for that tax year, she only reported income of $39,000. Janice has a large student loan balance, and could get the student loan interest deduction.
But the following year, Janice reports an income of $78,000. She now makes too much to qualify for the student loan interest deduction. If she had done her taxes herself the year before, she would have realized that she is disqualified for taking the student loan interest deduction because her income and consequent MAGI is greater than $75,000. If she had contributed at least $3000 to her 401k, she would have reduced her MAGI by at least $3000 and been able to claim a small deduction (the student loan interest deduction is phased out once her income hits $60,000). She also could have gotten almost the full deduction by contributing the max to her 401k ($17,500). But that probably wouldn’t have been a great idea because then that’s less money she can put towards her actual loan which has a 6.8% interest rate. But, a contribution of $3000 is not very much – and she gets a 100% match of the first 6% of her salary – which she should always maximize!
The above was maybe not the best example. But the point still stands – without filling out your taxes by hand, it’s hard to plan ahead to minimize future tax bills. And remember, an understanding of taxes is necessary to make an informed decision about Traditional vs Roth accounts. You can read about taxes all you want, whether it’s on my blog or elsewhere, but it’s one thing to read about something and another to actually apply the lessons learned.
You can outsmart tax software
As I said above, I’ve done this before. Now, the software wasn’t wrong. It was 100% correct. It just used the wrong optimization criteria—it minimized federal and state tax liabilities separately, whereas I’m interested in minimizing my total federal + state liability.
I am a graduate student that receives fellowship money. I can claim part of this fellowship money was used tax free towards qualified higher education expenses (QHEE), which last year was $2774. Doing this lowers the portion of my fellowship money subject to tax. Hence, I can effectively get a $2774 federal tax deduction.
Or, I could claim the Lifetime Learning Credit. The American Opportunity Tax Credit is more lucrative, but can only be used for four years of higher education. With the Lifetime Learning Credit, I can get back 20% of my QHEE as a tax credit.
Now, as a grad student, my federal tax bracket is 15%. Hence, because my federal tax bracket of 15% is less than the credit value of 20%, I should take the credit right? This is what the software recommended.
But remember, I’m interested in minimizing my federal + state tax liability. My state uses my federal AGI as the starting point for my state return’s AGI. My marginal state tax rate is 6%. My state does not have a tax credit for QHEE.
So, by claiming that I used the fellowship money for QHEE, I effectively get a 15% tax deduction on my federal returns, and a 6% tax deduction on my state returns. Hence, this will save me 21% of $2774 = $582.54 in my total tax liability, whereas taking the federal tax credit will only save me 20% of $2774 = $554.80.
Now granted, the difference is quite small – only $27.74. But it is there. And this is only one example. I’m sure there exist other examples where the difference between what you can do by hand and what tax software will do is far greater.