Taxes and Insurance

Week 5 Taxes and Insurance

By Dr. Mark Skousen, Grantham University

“Economy is a great source of revenue.” – Seneca

Last week we discussed how to save thousands on transportation (using public transportation, buying used cars, etc.) and housing expenses (renting, refinancing, etc.). This week we will continue with our goal of cutting the cost of living without cutting our standard of living.  

 By making cost-cutting a game, you can make surprising reductions in expenses for food, entertainment, clothing, and appliances. Reduce food costs by planning ahead, shopping around, and eating out less frequently. Reduce entertainment costs by using RedBox or Netflix instead of paying full price at a movie theater. Shop around and wait for “sales” announcements to buy clothes and appliances at deep discounts. Classified ads are another great way to find things at lower prices to cut expenses.   

Two excellent “how to” books (also available on Kindle) on cutting the cost of living without cutting the standard of living are by personal finance expert Jeff Yeager: 

The Ultimate Cheapskate’s Road to True Riches (2007) at 

http://www.amazon.com/Ultimate-Cheapskates-Road-True-Riches/dp/0767926951 and

The Cheapskate Next Door: The Surprising Secrets of Americans Living Happily Below Their Means (paperback) (2010) at

http://www.amazon.com/Cheapskate-Next-Door-Surprising-Americans/dp/0767931327/ref=pd_sim_b_1

Jeff Yeager’s free website at http://ultimatecheapskate.com is full of good advice and updates.

The Growing Tax Burden

I n this session, two of the most expensive items in your budget – taxes and insurance – are discussed along with how to minimize them without losing benefits. Let’s start with taxes.   

In the late 90s, the tax burden on middle-income workers in America hit an all-time high, roughly 38% of their income, or $23,000 a year in federal, state and local taxes. That is more than the typical family pays for food, clothing, housing, and transportation, yearly. 

The Tax Foundation publishes Tax Freedom Day, a creative way to demonstrate the tax burden in the United States. They determine the number of days it would take each year to pay all your taxes (at all levels). 

Here is a “Tax Freedom Day and Tax Burden” Table highlighting select years over the past 110 years.

Table X: Tax Freedom Day and Tax Burden, Select Years 1900-2011

 

Year	Tax Freedom Day	All Taxes as a Percentage of Income
1900	January 22	5.9%
1930	February 12	11.7%
1960	April 11	27.7%
1990	April 21	30.4%
2000	May 1	33.0%
2011	April 12	27.7%

Source: The Tax Foundation:  www.TaxFoundation.org

Since the late 90s, the tax burden has declined a bit (see graph below), but the tax break won’t last long. Unless the federal budget is cut, government spending will rise so rapidly that taxes will have to be raised substantially,  

The Rise and Fall of the Tax Burden – and the Rise Again

Source: Heritage Foundation.  www.heritage.org

Tax Dos and Don’ts

Oliver Wendell Holmes famously wrote “Taxation is the price we pay for civilization” (reprinted on the IRS headquarters in Washington DC). 

Could we pay less for civilization? 

Ben Franklin said: “A virtuous and industrious people may be cheaply governed.” 

Do we have cheap government? 

I’ve asked these questions to all kinds of groups, which include Republicans and Democrats, and they all agree -- government is expensive and getting more expensive. While you may be able to do little, politically, to reduce the level of taxation in this country, you may be able to reduce your tax liability -- legally. The ability to legally cut your taxes all revolves around your personal understanding of the Tax Code, and how it might apply to you.  Sounds daughting, but it is really not that difficult.

For instance, one third of American families overpay their income taxes because of ignorance of the tax law (Margolis, Sidney, How to Make the Most of Your Money).

According to recent studies by economists and the IRS, a large part of the population over pay their taxes, and are hit with unnecessary penalties and interest because of improper or inadequate filings. Part of the reason is the IRS and Congress has made the tax regulations so complicated that even many lawyers have trouble determining exactly what they owe. 

In addition, many people over pay their taxes because they are afraid. The IRS has done a good job of creating fear through its “partners” in the national news media. Many people would rather overpay their taxes rather than risking going through the harrowing experience of an audit--this is exactly what the IRS wants. The IRS has only enough agents to audit 2% of the tax returns filed annually, so they must rely on “voluntary compliance” from the other 98%. Consequently, the IRS intimidates citizens to the point of being faced with a gray area of tax deduction and then citizens choose to pay it rather than claim it. To be honest, if you have never been audited, you are probably paying too much.

Moreover, beware of dangerous tax evasion schemes. You should not get involved in crazy tax shelters, tax havens, or tax evasion schemes that could land you in jail or with heavy fines. 

All too often, a naïve citizen gets involved in a scheme to eliminate or save on taxes, only to be audited, hit hard financially, or deliberately fail to report taxable income. Don’t let it happen to you. Stay away from tax protestors who urge you to stop filing or paying income taxes, or engage in suspicious offshore tax haven schemes. They can only get you into trouble in the long run. There are many legitimate ways to cut your taxes, so why take the risk with illegal or questionable tax schemes? Stick with real tax techniques that work. 

Judge Learned Hand has said, “There’s nothing sinister in so arranging one’s affairs as to keep taxes as low as possible.” 

The following strategies are legitimate tax saving tools to legally enable you to reduce your tax liability.

Invest your savings in a tax-sheltered retirement account, like an IRA, 401(k) or SEP or other qualified tax sheltered savings plans.

One of the best places to save money in taxes and to build your wealth is by investing monthly in an Individual Retirement Account, 401(k) account. Or, if you are self-employed, a SEP account, a paycheck withholding or an Automatic Investment Plan (AIP) with a local bank or brokerage firm as discussed in Module #3. 

The advantages are excellent. Contributions are tax deductible and accumulate free of taxes on capital gains, interest or dividends until you withdraw the money (required by age 70 ½). The downside is that your money is tied up for long periods, BUT it has a silver lining -- it’s a forced savings plan. 

In the case of a Roth IRA, you don’t get a deduction when you make a contribution, but your gains are tax free while inside the Roth IRA and also tax free when you withdraw the money. Roth IRAs are ideal for those who invest for the long term and have superior capital gains. For example, suppose you invest $1,000 in a company with a great future -- a future Microsoft or Apple Computers -- and the stock goes from $1 to $100 in 10 years. Your $1,000 will be worth $100,000 in ten years. You can take the money out and it’s all yours! Uncle Sam gets nothing! 

For self-employed entrepreneurs, consider setting up a Simplified Employee Pension (SEP) account. SEP allows employers to set aside up to 25% of a workers’ salary into a tax-deferred retirement account.

For more information, go to http://www.smartmoney.com/personal-finance/taxes/what-are-your-ira-options-9563/.

For 401(k) contributions through your employer

http://www.irs.gov/retirement/participant/article/0,,id=151786,00.html                 

For information about SEP Plans, http://www.dol.gov/ebsa/publications/SEPPlans.html

Note: If you designate your favorite charity, church, alma mater, or any organization that qualifies as a tax-exempt organization as the beneficiary of your IRA or 401k plan, you can avoid estate and inheritance taxes. Check with your tax advisor for details. 

Set up a Sub S. Corporation

 

If you have a successful part-time or full-time business, an S corporation may have considerable tax and business advantages. I have one myself and it’s a great way to do business and save money. Notice I said “successful” business. In most cases, it’s best not to set up an S corporation until you start making money. Start simple with a single proprietorship and file a Schedule C business return each year until you start making real money. 

When you are successful, consider converting to an S corporation. It offers the benefits of incorporation, such as protection of limited personal liability, but you pay no corporate income taxes. All profits pass through to the individual shareholders that appear on your personal return (no double taxation). A single person can set up an S corporation. Not only does the S corporation allow you to deduct all kinds of business-related expenses (travel, hotel, meals, telephone and cable television, and capital equipment), you can also minimize the self-employment tax and FICA tax. The FICA taxes only apply to the “reasonable” salary that you must pay yourself and your employees. Revenues that come in beyond that are subject to personal income tax, but are exempt from Social Security and Medicare taxes. That can amount to savings of thousands of dollars in FICA taxes if you earn more than $100,000 a year. 

Having your own business allows you to buy equipment such as a computer, printer, fax machine, iPhone, furniture and other business-related tools and capital, and all of it is immediately deductible as an expense, up to $500,000 (2010 Small Business Jobs Act). 

Of course, it costs money to set up and administer an S corporation, but fees can be minimized by shopping around, especially if you incorporate in a low fee state, such as Delaware or Nevada. For details, go to http://www.incorporate.com

Sell Used Goods and Pay No Tax

Here’s an easy way to raise a lot of cash and pay no income or capital gains tax: have a garage sale! Almost all items sold at a garage sale, online, or in the classifieds, are not subject to income or capital gains tax -- unless you get more than you paid. Almost all used goods sell at a substantial discount to what you paid. You can therefore pocket the money from these private sales and pay no tax. 

Special Tax Breaks for Charitable Donations

Most of you know that donations in the form of cash, checks, credit card payments, or appreciation assets (stocks or real estate) are tax deductible if you itemize. 

One of the best tax-favored investments is called a Charitable Remainder Trust. This legal vehicle is a way to donate your property, such as appreciated publicly-traded stocks or real estate, to your favorite charity and get a monthly income or annuity for the rest of your life. You also qualify for a tax deduction, depending on the amount and your age. When you die, the charitable organization (church, alma mater, or favorite think tank) receives the value of the remaining assets. 

For more information on Charitable Remainder Trusts, here is a good source: http://www.savewealth.com/planning/estate/charitabletrusts/

Other Tax Breaks

For more tax deductions and exemptions, read the following sites from Kiplinger Magazine: 

http://www.kiplinger.com/features/archives/2009/04/diyalltaxpayers.html and http://www.kiplinger.com/features/archives/the-mostoverlooked-tax-deductions.html

If you are not a self-employed person there are still opportunities. Many of the expenses associated with your job may be deductible business expenses and can be claimed under unreimbursed business expenses. If your employer, for example requires you to wear special clothing but does not provide them you can deduct it. Don’t forget mileage associated with medical care, automobile expenses if you use your personal care for company business. For military service members excessive costs of frequent moves can be a possible deduction area, frequent temporary duty has a way of running up expenses which could also qualify, and even the costs of professional books and education required to maintain your proficiency and competitiveness. As always these are technical areas, and you are best advice to consult a solid tax preparer and pay for the advice which can save you a lot of money. Yes the cost of such advice is also tax deductible.

The Truth about Insurance

The average American family can spend anywhere from $3,500 to $10,000 on various types of insurance, and sometimes a great deal more. Medical insurance can cost $3,000 or more, and is rising fast; car insurance can be $1,800 or more, depending on the kind of car you drive, you age and your driving record; homeowners insurance can cost you anywhere from $1,000 to $5,000, depending on the value of your home; and life insurance rates vary dramatically depending on whether you buy a term or a whole life policy.

When considering insurance, first think about the following: Have a basic understanding of insurance and why you need it. The purpose of insurance is to protect you against the possibility of a financial disaster should something happen to you or your family members, far beyond your capability to pay for the consequences. 

The key to controlling your insurance costs is to cover only for those unpredictable events in life that could be a major financial setback if they should happen. However, you must guard against being over insured. For example, there’s no need to buy insurance against occasions that won’t hurt you much financially. A few examples are:

Ordinary visits to your dentist for cleaning your teeth. It might cost you less than $100 per visit. It’s cheaper to pay for ordinary dental visits rather than buy dental insurance. 

Collision insurance for used cars that have little resale value. Full medical coverage for injuries, if your used car is worth only $1,000 is not worth buying replacement coverage. 

Insurance of all types is clearly expensive but at the same time very valuable to families. The younger you are the more dangerous insurance companies’ think you are for such converges as automobile and homeowners. Conversely, medical insurance and life insurance are relatively inexpensive. There is an opportunity here, especially for service members. While all of your medical insurance is covered for you and your family on active duty, life insurance is relatively inexpensive. If you take the long view and consider lifetime costs, you should ideally buy all you will ever need when you are young and less likely to need it. Later when you have to replace employer health cover ages at retirement you will therefore have more free cash flow to meet the high costs of such protection.

Two Ways to Save Money on Insurance

 

You can save a lot of money by doing two things when it comes to buying insurance: 

First, raise your deductible on home owners, auto insurance, and medical insurance. You can afford to pay the deductible if you are in a car accident or your property is stolen. Meanwhile, you can save hundreds of dollars in premiums by keeping the deductible high. 

Second, shop around for the best policies. There are significant differences in insurance rates for autos, medical, and life insurance.

Buying Life Insurance

Term life insurance is especially cheap these days, now that states and the federal government allow competition between insurance companies. A 35-year old non-smoking male can pay less than $2,000 a year for a million dollar insurance policy. You can get quotes from five insurance companies on term policies by going to http://www.freelifetermquote.com/

Insurance is an individual thing and there are no formulas for being able to precisely tell one what they need and what type they should have. There are permanent needs and temporary needs and there are permanent and temporary insurances to cover them. Again you should buy what you need as soon as you can and there is the cost savings over a lifetime. Buying term and investing the difference is a bankrupt philosophy which does not work because life never unfolds the way you plan it. Also recall, that less than 2% of temporary policies ever pay off and that is a current 2011 statistic provided by the National Association of Insurance Commissioners.

Whatever policy you decide to buy, make sure you check the financial rating of the insurance company by A. M. Best, Standard & Poors, and Weiss. Details can be found at http://www.insbuyer.com/insurancenrating.htm

The Rising Cost of Medical Insurance

The United States faces serious challenges in the field of healthcare. The US spends more money per capita on healthcare than any other country, yet it has a mediocre life expectancy of only 78 years. 

More healthcare spending means a longer life, except the US does a relatively poor job in preventing disease, but a better job in curing it. A recent survey by the United Nations International Health Organization compared the US medical system with England and Canada (both have socialized medicine). Americans have a much better chance of surviving cancer and diabetes and can more easily see a medical specialist, get an MRI, or a hip replacement. 

Medical insurance offered by your employer is expensive and getting more and more costly. The reasons vary, but the biggest reason is that someone else, other than the consumer, is footing the bill. Today 70% of all medical bills are paid for by a third party rather than the customer; the federal and state governments are paying most of the bills of seniors and the poor; and employers and insurance companies are paying most of the bills of employees. As a result, there is little incentive to shop around for the best price. In short, the free market is not allowed to operate normally in the health care marketplace, and costs are getting out of control. 

Source: The Economist, March 11, 2011

Health Savings Accounts (HSAs)

Some companies are offering Health Savings Accounts (HSAs-tax-deferred accounts) that allow you to save money for medical expenses.             Whole Foods Market offers an HSA called “Personal Wellness Accounts.” The company pays 100 percent of the premiums for all-full time workers, who are automatically enrolled. However, there is a high deductible of $3,500: $1,000 in medical costs, $500 deductible for prescription drugs, and $2,000 in co-pays (both company and worker co-pay for costs). Each employee (“team member”) is given a MasterCard debit card which they can access for “health and wellness” expenses. (The company tracks carefully MasterCard expenses to make sure charges are only for medical related items.)

If employees don’t use all of the deductible, the remaining funds are placed into a HSA, which builds up tax-free until withdrawn. HSAs are portable, so workers can take the account with them if they move to another company. HSAs create an incentive for workers to become smart health-care consumers because they can keep money that is left over. They have two options for handling unspent HSA funds:

They can save money (tax-free) for future medical expenses and the interest that also accrue tax-free; or

They can withdraw money from the HSA at the end of the year, but would need to maintain a minimum balance. 

Nonmedical withdrawals would be fully taxed and subject to a 15 percent tax penalty. “Some of our team members are going to have $8,000, $9,000, and even $10,000 tucked away in their accounts,” states CEO John Mackey of Whole Food Market. “They don’t have to worry about going bankrupt due to medical problems.” 

The results have been phenomenal. The turnover rate has plummeted to around 20 percent. Company medical costs have dropped substantially. Forty-five percent of employees don’t use their HSA at all. Why not? Because they were healthy, not sick; 74% spend less than $500 on their HSA. 

Now, for the first time, Whole Food Market employees have an incentive to shop around for medical services. The high deductible encourages them to shop around and find the best deal. They are encouraged to eat healthy foods and to exercise. By reducing the number of visits to doctors and hospitals, they can save money in their HSA. John Mackey calls it “an empowered model.” 

According to Forrester Research, by 2010, twenty-four percent of the health insurance market will be consumer-driven health plans (HSAs). It is the future of American health care. See if your company offers an HSA. 

Long Term Care

This is another area where caution is in order. The inevitability for needing long term care is fairly high and many people, even those with substantial assets are without this coverage. It is another example of aging too quickly and not thinking about consequences. These policies are expensive as stand-alones, but some companies are adding long term care riders on an indemnity basis (as opposed to reimbursement), to permanent life insurance policies and the cost of such protection is most reasonable.