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Should I Prepare My Own Tax Return?

A reader writes in, asking:

“This is my first time having to file a tax return since getting a ‘real job’ and my head is spinning. Should I hire a CPA to do my taxes or is it better to use software for it myself? I’ve read that Turbotax guarantees the highest refund possible. Is it really better than hiring a CPA?”

Without a doubt, using a tax professional is the most reliable way to get the lowest tax bill. A key point here is that tax professionals use tax preparation software too, so using such software yourself does not provide you with any advantage over a professional.

That said, there are valid reasons for taking a DIY approach. Most obviously, you save on fees. Buying a download of TurboTax or other similar software certainly costs less than hiring a professional.

More importantly in my opinion though is that by preparing your own return for the first time, you’ll learn quite a bit about how income taxes work.

In my work, I frequently come across people who have been paying income taxes for decades, yet they don’t understand even the most basic income tax concepts (e.g., they misunderstand how tax brackets work, or they don’t know the difference between a deduction and a credit). Every year, they simply turn over all of their documents to somebody else who prepares their return, and so they go years without learning these things. Naturally, it’s impossible to make very good decisions about tax planning when you don’t understand the fundamental concepts.

In addition to allowing you to make smarter financial decisions, having a better understanding of income taxes allows you to be a more well-informed voter. It’s very common for politicians to propose various changes to our tax code (e.g., creating a new deduction or credit, or eliminating/changing an existing deduction or credit). If you don’t understand how the system works now, you can’t really understand the impact of proposed changes.

My point here isn’t that everybody should be preparing their own tax returns. It depends on your goals, and it depends on how complicated your return is. (If you’re already at the point where you have investments in taxable accounts, you itemize your deductions, and you have income from a rental property, then it’s going to be quite a challenge to prepare your own tax return if you’ve never prepared a return before.)

In summary, if you want to learn more about income taxes, you want to save on tax prep fees, and/or your return isn’t too complicated, those are all points in favor of preparing your own return. But it’s unlikely that your tax bill will be lower as a result of taking a DIY approach rather than hiring a professional. In most cases, the outcome that you’re hoping for with a DIY approach is that your return will turn out exactly the same as it would have if a professional had prepared it.

 

For More Information, See My Related Book:

Book6FrontCoverTiltedBlue

Taxes Made Simple: Income Taxes Explained in 100 Pages or Less

Topics Covered in the Book:
  • The difference between deductions, exemptions, and credits,
  • Itemized deductions vs. the standard deduction,
  • Several money-saving deductions and credits and how to make sure you qualify for them,
  • Click here to see the full list.

A testimonial from a reader on Amazon:

"Very easy to read and is a perfect introduction for learning how to do your own taxes. Mike Piper does an excellent job of demystifying complex tax sections and he presents them in an enjoyable and easy to understand way. Highly recommended!"

2017 Tax Brackets, Standard Deduction, Personal Exemption, and Other Updates

Every year, I publish a brief update with the following year’s tax brackets, standard deduction, and so on. This year, there is more uncertainty, as the likelihood of a legislative change happening in early 2017 and actually being effect for 2017 is somewhat higher than normal. Still, what follows is the information as it stands now. If you want additional details, the official IRS announcement can be found here.

The tax brackets for 2017 are as follows:

Single 2017 Tax Brackets

Taxable Income
Tax Bracket:
$0-$9,325 10%
$9,326-$37,950 15%
$37,951-$91,900 25%
$91,901-$191,650 28%
$191,651-$416,700 33%
$416,701-$418,400 35%
$418,401+ 39.6%

 

Married Filing Jointly 2017 Tax Brackets

Taxable Income
Tax Bracket:
$0-$18,650 10%
$18,651-$75,900 15%
$75,901-$153,100 25%
$153,101-$233,350 28%
$233,351-$416,700 33%
$416,701-$470,700 35%
$470,701+ 39.6%

 

Head of Household 2017 Tax Brackets

Taxable Income
Tax Bracket:
$0-$13,350 10%
$13,351-$50,800 15%
$50,801-$131,200 25%
$131,201-$212,500 28%
$212,501-$416,700 33%
$416,701-$444,550 35%
$444,551+ 39.6%

 

Married Filing Separately 2017 Tax Brackets

Taxable Income
Marginal Tax Rate:
$0-$9,325 10%
$9,326-$37,950 15%
$37,951-$76,550 25%
$76,551-$116,675 28%
$116,676-$208,350 33%
$208,351-$235,350 35%
$235,351+ 39.6%

 

Standard Deduction Amounts

The 2017 standard deduction amounts will be as follows:

  • Single or married filing separately: $6,350
  • Married filing jointly: $12,700
  • Head of household: $9,350

The additional standard deduction for people who have reached age 65 (or who are blind) is $1,250 for married taxpayers or $1,550 for unmarried taxpayers.

Personal Exemption Amount and Phaseout

The personal exemption amount for 2017 is $4,050.

However, the total personal exemptions to which you’re entitled will be phased out (i.e., reduced and eventually eliminated) as your adjusted gross income (i.e., the last line of the first page of your Form 1040) moves through a certain range.

  • For single taxpayers, personal exemptions begin to be phased out at $261,500 and are fully phased out by $384,000.
  • For married taxpayers filing jointly, personal exemptions begin to be phased out at $313,800 and are fully phased out by $436,300.
  • For taxpayers filing as head of household, personal exemptions begin to be phased out at $287,650 and are fully phased out by $410,150.
  • For married taxpayers filing separately, personal exemptions begin to be phased out at $156,900 and are fully phased out by $218,150.

Limitation on Itemized Deductions

As was the case for the last few years, the amount of itemized deductions which you are allowed to claim is reduced by 3% of the amount by which your adjusted gross income exceeds certain threshold amounts. These threshold amounts are the same as the lower threshold amounts listed above for the personal exemption phaseout (e.g., $261,500 for single taxpayers). However:

  1. Your itemized deductions cannot be reduced by more than 80% as a result of this limitation, and
  2. Your itemized deductions for medical expenses, investment interest expense, casualty/theft losses, and gambling losses are not reduced as a result of this limitation.

IRA and 401(k) Contribution Limits

For 2017, the contribution limit to Roth and traditional IRAs is unchanged at $5,500, with an additional catch-up contribution of $1,000 for people age 50 or older.

The contribution limit for 401(k), 403(b), and most 457 plans is unchanged at $18,000, with an additional catch-up contribution of $6,000 for people age 50 or older.

The maximum possible contribution for defined contribution plans (e.g., for a self-employed person with a sufficiently high income contributing to a SEP IRA) is increased to $54,000.

AMT Exemption Amount

After adjusting for inflation, the following are the AMT exemptions for 2017:

  • $54,300 for single taxpayers,
  • $84,500 for married taxpayers filing jointly, and
  • $42,250 for married taxpayers filing separately.

For More Information, See My Related Book:

Book6FrontCoverTiltedBlue

Taxes Made Simple: Income Taxes Explained in 100 Pages or Less

Topics Covered in the Book:
  • The difference between deductions, exemptions, and credits,
  • Itemized deductions vs. the standard deduction,
  • Several money-saving deductions and credits and how to make sure you qualify for them,
  • Click here to see the full list.

A testimonial from a reader on Amazon:

"Very easy to read and is a perfect introduction for learning how to do your own taxes. Mike Piper does an excellent job of demystifying complex tax sections and he presents them in an enjoyable and easy to understand way. Highly recommended!"

How Do You Calculate the After-Tax Interest Rate on a Mortgage?

A reader writes in, asking:

“I’m in the process of buying my first home, and I keep reading about how I need to know the after tax interest rate on my mortgage. Does that just depend on my tax bracket or is there more to know here?”

If you’re already itemizing every year before you take out a mortgage, the calculation is simple. The after-tax interest rate on the mortgage is the interest rate, multiplied by (1 – your marginal tax rate). In other words, it’s the interest you pay, minus the tax savings you get back.

Example: Celeste is unmarried, with a standard deduction of $6,300 per year. She’s in the 25% federal tax bracket and 5% state tax bracket, for a total marginal tax rate of 30%. She already has itemized deductions totaling $10,000 per year, so she chooses to itemize each year rather than use the standard deduction. If she takes out a mortgage with an interest rate of 4%, the after-tax interest rate on her mortgage will be 2.8% (calculated as 4% x 0.7, because she gets 30% of the mortgage interest back in the form of tax savings).*

But in a situation in which you don’t already itemize, a part of the deduction is essentially wasted, because all it’s doing is bringing your itemized deductions up to the level of deduction you would have already had with the standard deduction. And it’s only the amount beyond that point that’s actually saving you any money on your taxes.

Example: Martin and Johanna are married, with a standard deduction of $12,600 per year. They’re in the 25% federal tax bracket and 5% state tax bracket, for a total marginal tax rate of 30%. Prior to taking out a mortgage, their itemized deductions are just $7,000 per year, so they currently choose to use the standard deduction each year. They’re considering taking out a mortgage with an interest rate of 4%.

Despite the fact that Martin and Johanna have the same marginal tax rate as Celeste, and are considering a mortgage with the same interest rate, their after-tax interest rate on the mortgage will be higher than hers, because they will get less tax savings from the deduction than she gets. Specifically, the first $5,600 of their deduction for home mortgage interest will serve no purpose other than to bring their itemized deductions up to the level of the standard deduction. They will only achieve tax savings for any home mortgage interest they pay that is in excess of $5,600 per year.

So for Martin and Johanna to calculate their after-tax interest rate for the first year of such a mortgage, they would calculate the amount of interest they would pay over the course of the year, then subtract $5,600. The resulting amount would be multiplied by 30% (their marginal tax rate) to determine the amount of their tax savings. Then they would subtract that tax savings from the amount of interest they paid over the year to determine the after-tax amount of interest they paid. And if they divide that after-tax interest amount by the outstanding balance on their mortgage, they’ll arrive at their after-tax interest rate.

A key point here is that Martin and Johanna will have to revisit this calculation whenever they want to know the after-tax interest rate on their mortgage, because the figures involved will change over time. (For instance, the amount of interest they pay each year will decline over time as they pay down their mortgage balance. And their itemized deductions from things other than home mortgage interest will change over time as well.)

*This is a simplification. As we’ve discussed before, your marginal tax rate is not necessarily the same as your tax bracket, but I’m keeping things as simple as possible in our examples. We’re also assuming here that all of the interest on the mortgage does qualify for a deduction. (IRS Publication 936 has the details on that topic.) In addition, if you are itemizing, your state income tax can be claimed as a deduction against your federal taxable income, thereby slightly reducing your overall marginal tax rate.

For More Information, See My Related Book:

Book6FrontCoverTiltedBlue

Taxes Made Simple: Income Taxes Explained in 100 Pages or Less

Topics Covered in the Book:
  • The difference between deductions, exemptions, and credits,
  • Itemized deductions vs. the standard deduction,
  • Several money-saving deductions and credits and how to make sure you qualify for them,
  • Click here to see the full list.

A testimonial from a reader on Amazon:

"Very easy to read and is a perfect introduction for learning how to do your own taxes. Mike Piper does an excellent job of demystifying complex tax sections and he presents them in an enjoyable and easy to understand way. Highly recommended!"

How Do Interest Rates and Dividend Yields Affect Asset Location?

For many years, the conventional wisdom with asset location has been that, if you have to hold some investments in taxable accounts (as opposed to being able to keep everything in retirement accounts), it’s better to hold stocks rather than bonds in the taxable account, given the favorable tax treatment of qualified dividends and long-term capital gains.

This conventional wisdom overlooks the fact that tax efficiency depends not only on the tax rate you would have to pay on the income generated, but also on the amount of income generated.

As an extreme example: If you own 1-month Treasury bills, yes, they generate interest that is fully taxable at the federal level, but the amount of that interest is so small that the total return lost to taxes will actually be quite low.

Calculating Expected Tax Costs

When deciding which fund(s) you will hold in your taxable account, it can be helpful to calculate the approximate tax cost for each of your various holdings.

For example, if you live in Missouri and you’re in the 25% federal tax bracket and 6% state tax bracket:

  • Ordinary interest income would be taxable at a 25% federal tax rate and 6% state tax rate,
  • Treasury bond interest would be taxable at a 25% federal tax rate but untaxed at the state level, and
  • Qualified dividends and long-term capital gains would be taxed at a 15% federal tax rate and 6% state tax rate.

So, we can use that information to get a rough estimate of the tax cost you would likely incur as a result of holding various funds in a taxable account.

In other words, the stock fund will probably result in a higher tax cost than either of the Treasury funds, and that’s not even including the eventual capital gains tax that you will (probably) owe on price appreciation for the stock fund.

Figuring out a ballpark estimate of the tax cost for something like Vanguard Total Bond Market Index Fund is a bit trickier, because approximately 40% of the fund is invested in Treasury bonds (which aren’t taxed at the state level), while the rest of the fund is invested in bonds that are taxed at the state level. The fund currently has an SEC yield of 1.74%. We can multiply 40% of that yield by a tax rate of 25% and the remaining 60% of that yield by a tax rate of 31% to determine that the fund would have a tax cost of very roughly 0.50%. But this understates the cost somewhat because the Treasury bonds account for less than 40% of the yield despite being 40% of the portfolio.

In short, the idea that stocks are more tax-efficient than bonds is only sometimes true. It depends which bonds and which stocks we’re talking about. And it depends on whether interest rates (and dividend yields) are currently high or low. With interest rates as low as they are right now, bonds are more tax-efficient than they would otherwise be. And as you can see above, some taxpayers will find that certain taxable bond funds are currently more tax-efficient than stock funds.

For More Information, See My Related Book:

Book6FrontCoverTiltedBlue

Taxes Made Simple: Income Taxes Explained in 100 Pages or Less

Topics Covered in the Book:
  • The difference between deductions, exemptions, and credits,
  • Itemized deductions vs. the standard deduction,
  • Several money-saving deductions and credits and how to make sure you qualify for them,
  • Click here to see the full list.

A testimonial from a reader on Amazon:

"Very easy to read and is a perfect introduction for learning how to do your own taxes. Mike Piper does an excellent job of demystifying complex tax sections and he presents them in an enjoyable and easy to understand way. Highly recommended!"

Does Tax-Loss Harvesting Occur within Funds of Funds?

A reader writes in, asking:

“I’ve read on your blog and elsewhere that funds of funds are not tax efficient because they don’t allow for tax loss harvesting. But doesn’t holding a target retirement fund achieve tax loss harvesting anyway since when one of the funds inside the portfolio goes down it causes a loss, which offsets the gains? And I guess I have the same question with regular index funds. Don’t they achieve tax loss harvesting because some stocks are going down while others are going up?”

In short, the answer to both questions is “no.”

In order for tax-loss harvesting to occur, you have to actually sell the holding that has gone down. That’s what makes for a capital loss in the eyes of the tax code. Simply holding an investment that has declined in value isn’t a capital loss.

Why All-in-One Funds Don’t Usually Tax-Loss Harvest

Let’s look at the Vanguard LifeStrategy Moderate Growth Fund as an example. The fund’s targeted allocation is as follows:

  • 36% Vanguard Total Stock Market Index Fund,
  • 24% Vanguard Total International Stock Index Fund,
  • 28% Vanguard Total Bond Market II Index Fund, and
  • 12% Vanguard Total International Bond Index Fund.

For the fund to tax-loss harvest it would have to sell one of these holdings after a decline. But it’s unlikely to do that because:

  1. When a holding is down, the fund usually has to buy more of it in order to get back to the targeted allocation, and
  2. The fund cannot decide to substitute other similar funds in the way that an individual investor can (e.g., selling Vanguard Total Stock Market Index Fund to tax-loss harvest, then buying Vanguard Large-Cap Index Fund as a temporary substitute).

Why Regular Index Funds Don’t Tax-Loss Harvest (Very Much)

With a regular index fund, buying and selling within the fund happens primarily as a way to either use up cash inflows or satisfy redemptions. And in each case, the buying/selling will generally be approximately proportional to the existing allocation in the fund. For example, if an S&P 500 index fund currently appropriately reflects the S&P 500 and it needs to raise a significant amount of cash, it cannot simply choose to raise the cash by selling one stock that is down recently — otherwise the fund would no longer reflect the index that it is trying to track. Instead, the fund has to sell a little bit of everything.

That said, when the fund does “sell a little bit of everything,” if the fund manager is conscientious about taxes, he/she will usually make a point to sell the shares that have the highest cost basis (thereby realizing the largest loss or smallest gain possible). But this is not the same level of tax savings that an investor could achieve if he/she was willing to sell all of a given holding when it is down and substitute some other similar holding.

For More Information, See My Related Book:

Book6FrontCoverTiltedBlue

Taxes Made Simple: Income Taxes Explained in 100 Pages or Less

Topics Covered in the Book:
  • The difference between deductions, exemptions, and credits,
  • Itemized deductions vs. the standard deduction,
  • Several money-saving deductions and credits and how to make sure you qualify for them,
  • Click here to see the full list.

A testimonial from a reader on Amazon:

"Very easy to read and is a perfect introduction for learning how to do your own taxes. Mike Piper does an excellent job of demystifying complex tax sections and he presents them in an enjoyable and easy to understand way. Highly recommended!"

Tax Changes: Protecting Americans from Tax Hikes Act of 2015

Late last month, Congress passed (and President Obama signed) the Protecting Americans from Tax Hikes Act (“PATH Act”) of 2015. The Act makes quite a lot of changes (click the previous link to see the full list), but from a personal finance standpoint, the most important thing it did was to make permanent several tax breaks that were expiring in the near future (or already expired in some cases).

Expired Provisions Brought Back

With regard to investing, likely the most important change is that the ability to make “qualified charitable distributions” from an IRA is now permanent. (It had previously expired at the end of 2014.)

With a qualified charitable distribution, a taxpayer over age 70.5 has his/her RMD for the year distributed directly to a qualified charitable organization, and the distribution satisfies the annual RMD requirement while being excluded from gross income. The benefit is that this is an exclusion from gross income rather than an itemized deduction (which is what you would ordinarily get for a charitable donation). This is relevant because it means that:

  • This income will not be included in your adjusted gross income (which plays a role in determining many things such as how much of your Social Security benefits will be taxable and whether you qualify for numerous credits/deductions), and
  • You can take advantage of this tax break even if you use the standard deduction.

Another tax break that had expired in 2014 but which is now brought back and made permanent is the ability to elect a deduction for state and local sales taxes instead of state and local income taxes. (This is of course particularly helpful for people who live in states with no income tax.)

Finally, the increased exclusion for employer-provided mass transit benefits is now made permanent. (Prior to the passing of this Act, the monthly limitation would have reverted to a $130 limit beginning in 2015. With the passing of the Act, it will be $250 for 2015 and $255 for 2016.)

Scheduled-to-Expire Provisions Made Permanent

Another important change is that the American Opportunity Credit is also made permanent. (It was previously scheduled to expire at the end of 2017.) The American Opportunity Credit is a credit of up to $2,500 per year for paying qualified higher education expenses for yourself, your spouse, or your dependent.

Similarly, the “enhanced” version of the child tax credit (which is simply a change to the calculation of the child tax credit that increases the amount of credit many taxpayers receive) is now made permanent rather than expiring at the end of 2017.

Likewise, the “enhanced” version of the earned income credit (which increases the amount of the earned income credit for married taxpayers and taxpayers with 3 or more children) is now made permanent rather than expiring at the end of 2017.

Changes to 529 Plans

The Act also makes two important changes to 529 accounts.

First, the definition of “qualified higher education expenses” for 529 accounts has been expanded to include the cost of computers, related equipment, software, and internet access if such equipment is to be used primarily by the beneficiary during any of the years the beneficiary is enrolled at an eligible educational institution.

Second, for 529 ABLE accounts (for disabled individuals), the residency requirement has been eliminated. Previously, a beneficiary was required to use the plan established by his/her state of residence.

Again, to be clear, these are just a few of the provisions which I am assuming are most likely to be relevant to a large number of readers. There are many provisions in the Act that I have not mentioned. If you’re interested in perusing the full list, see here.

For More Information, See My Related Book:

Book6FrontCoverTiltedBlue

Taxes Made Simple: Income Taxes Explained in 100 Pages or Less

Topics Covered in the Book:
  • The difference between deductions, exemptions, and credits,
  • Itemized deductions vs. the standard deduction,
  • Several money-saving deductions and credits and how to make sure you qualify for them,
  • Click here to see the full list.

A testimonial from a reader on Amazon:

"Very easy to read and is a perfect introduction for learning how to do your own taxes. Mike Piper does an excellent job of demystifying complex tax sections and he presents them in an enjoyable and easy to understand way. Highly recommended!"
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