Becoming a Millionaire - Taxes Are Actually an Asset!

Excerpted from
Missed Fortune 101: A Starter Kit to Becoming a Millionaire
By Douglas R. Andrew

Leverage your tax dollars to support your retirement and financial security.

Most of us are conditioned to view taxes as a liability. But are they really? It's true that when we owe the government tax, it represents a liability to us. However, tax revenues are often expended on public assets-roads, schools, parks, airports-education, and protection.

As explained in chapter 1, most governmental systems throughout the world have some method whereby the public is required to give back to society in the form of taxes. Most people don't object to paying their fair share of tax as long as the government exercises prudence and proper stewardship over public funds. It's when we feel we are paying more than our fair share, or we feel the government is wasting or mismanaging public funds, that we get riled.

What many Americans don't realize is the government has given us the opportunity to take a certain amount of control over the management of our civic assets. If we don't exercise choice and control, they will! When we take responsibility for our own financial well-being, our future retirement security, insuring our own health care, or supporting charitable organizations that care for the poor and needy, the government's need to intervene becomes less. Generally, government-funded programs of social services are expensive and inefficient. The Internal Revenue Code contains provisions whereby taxpayers can redirect otherwise payable taxes to causes they are passionate about that will also benefit their own families.

Why All The Tax Breaks?

Why do tax laws allow a taxpayer to deduct money contributed to an IRA from gross income and accumulate a retirement account on a tax-deferred basis?

When was the last time you washed a rental car or changed its oil? People don't wash rental cars; they wash and take care of the cars they own. The secret to American wealth lies within the freedom to own assets with deeds, titles, and articles of incorporation.

The government understands this premise, so similarly, they encourage you to take financial responsibility for your own retirement so you won't be a drain on public funds. The government also encourages you to postpone taxes to a future date so your funds will grow to a larger amount and likely be taxed at a higher rate, as I will explain in chapter 3.

Why do tax laws allow a taxpayer to deduct mortgage interest expense from their gross income? It's because home buyers stimulate the economy, which creates more tax revenue than the revenue they are giving up. The government would rather have its citizens owning their own home than living in subsidized housing or renting. People take care of assets when they have personal ownership of them. Why do tax laws allow a taxpayer to deduct money contributed to charitable causes? Because those civic dollars benefit society. Therefore, government welfare programs will have less demand on them.

Why do tax laws allow exemptions on a tax return for each dependent in the household? It's better for parents to care for the needs of their own children than to have government collecting additional tax and allocating it back for human services. It stands to reason, then, that the more choice and control we exercise over our civic assets, the less government will need to tax us to provide services we can provide for ourselves.

What if a 30-year-old couple could redirect $500 a month of otherwise payable income taxes to their retirement account? If they accumulated $500 per month for thirty-five years (to age 65) in a non-taxable environment at 7.5 percent interest compounded annually, it would grow to $1,021,727. They could withdraw $6,385 per month in interest thereafter ($1,021,727 x 7.5% = $76,630 12 months) and never deplete their principal. This book will teach you how to do this.

Remember that sweet, juicy orange encased in the bitter peel that I mentioned in the preface? Here's one of those moments when we'll need to "get through the peel" to arrive at a delightful principle. So bear with me in this chapter as I educate you on some basic tax laws and strategies that are necessary ingredients for making a dramatic difference in optimizing all of our assets.

Understanding Deductions

Fortunately, federal and state income taxes are calculated only on "taxable" income. Taxable income is calculated as gross personal income less personal deductions and exemptions. Deductions are usually allowed for expenses or investments that directly or indirectly contribute to various civic assets or otherwise stimulate the economy. Exemptions are allowed for dependents living in the household of the taxpayer. These deductions and exemptions are subtracted from the last, not the first, dollars you earn each year.

Hence, assuming a married couple filing jointly has a $70,000 combined gross income and has $20,000 in personal deductions and exemptions, their taxable income (the amount eligible for taxation by the federal and state governments) would be $50,000. If they were not able to claim $20,000 in deductions and exemptions, they would have paid a combined federal and state tax of $6,666-one-third of the last $20,000. That's money they would owe Uncle Sam and their state government if they didn't use those deductions. If the tax withheld from their paychecks during the year exceeded the amount they owe in taxes, this money would be refunded to them after they filed their joint tax return. Otherwise, if they owe taxes after completing their tax return, they would simply pay $6,666 less in taxes.

Under current tax law, there are three primary categories that American taxpayers most commonly deduct if they itemize deductions on Schedule A of their 1040 federal tax return:

• State income and sales taxes, as well as local taxes such as property' tax
• Cash and non-cash charitable contributions
• Qualified mortgage interest expense

Under hardship circumstances, excessive medical care costs and casualty and theft losses can also qualify for deductibility.

Marginal vs. Effective Tax Brackets

The tax bracket that your last dollars earned put you in is called your "marginal" tax bracket. Your marginal tax bracket is different from your "effective" tax bracket. Your effective tax bracket is the tax percentage rate you pay when compared to your total income. For example, a married couple with a combined income of $100,000 might be in a marginal federal tax bracket of 25 percent and a state tax bracket of 8 percent-a combined bracket of 33 percent.

But if you have deductions and exemptions of $30,000, perhaps comprised of mortgage interest, charitable contributions, and dependents in the home who qualify as exemptions, your taxable income might be $70,000. You might pay income tax of only 18 percent on the first $12,000 (which equals $2,160), 23 percent from $12,000 to $50,000 (which equals $8,740), and 33 percent on the remaining $20,000 (which equals $6,600) for a total of $17,500. This is only 17.5 percent of your $100,000 gross income-your effective tax bracket. Your marginal bracket is still 33 percent. Again, keep in mind this simple example does not include FICA or Medicare.

When analyzing the actual benefit of a tax deduction, you should calculate it using your marginal tax rate rather than your effective tax rate. For example, if you deduct $10,000 of mortgage interest, it reduces your taxable income because the $10,000 comes off the last dollars you earn. In this example, you would actually save 33 percent of $10,000, or $3,300 of otherwise payable income tax you wouldn't have saved without the deduction. Here's the simple rule: If you want to calculate the true tax savings achieved by virtue of deduction, you should always use the marginal tax rate times the amount of the deduction. This is always true unless other deductions and exemptions have already taken your gross income below the threshold. In that event, you may want to use the next lower tax rate to calculate the value of a new deduction.

When taxpayers have their tax returns completed by a tax preparer, they are often informed that they are on the verge of moving into the next higher tax bracket. In other words, their taxable income is about to cross the threshold from 15 to 25 percent or from 25 to 28 percent on federal tax. This alarms the taxpayer because of the misconception that all income up to that threshold, as well as any over that threshold, will be taxed at the higher rate. This is not true! You pay the higher rate only on dollars earned in excess of each tax threshold.