You Should Understand Your Largest Expense

Oh, you thought housing was your biggest expense? I doubt it. Most Americans spend more on taxes than anything else. Federal income tax, state income tax, local income tax, Social Security tax, Medicare tax, capital gains tax, tax for paid family leave, sales tax, utterly indecipherable taxes on cell phone and utility bills, tolls for bridges and tunnels, property tax, should I keep going? Some taxes are straightforward and unavoidable (gotta pay some extra percent in sales tax to buy that thing at the store), but you have substantial control over others.

If you want to win the game, you have to learn the rules. Federal income tax in the U.S. gives you a lot of room to win. Congress wants us to save for retirement and build wealth, so they gave us tax incentives to help us do it. Is it easier for rich people to take advantage? Yeah, it is. So what? Vanguard doesn’t care what your income is, they’d love to help you start an IRA.  

Of course, I’m biased about this, because I started doing my own taxes while I was still in college and looking back I can clearly see how getting this personal finance education in my early 20’s set me up to make financial choices that helped me for the rest of my life. So, beyond a general feeling that we should understand the big dollar things in our lives, here are 4 specific reasons why I think you should learn how taxes work:

DIY saves money: If you understand how taxes work, you’ll have the confidence to prepare them yourself and save a few bucks. For me, this has probably been the least important financial benefit from understanding taxes, but perhaps the most important psychological benefit (more on that later). I spend a few hours a year working TurboTax for my household taxes, earning an effective “wage” from in-sourcing over $100 an hour. That’s an easy decision for me.

Tax optimization makes you richer: Like I said above, U.S. tax code gives lots of tax breaks to encourage retirement saving, and I love knowing that I’m taking advantage of these. At my job I can save in a HSA (yes, an HSA can be used to save for retirement!) and I can see right on my paystub that less taxes are withheld because of my HSA contribution. It feels like the tax code sets me up for this goal of maxing out my tax advantaged savings, and I get excited when I can hit that target.

The ability to do my own analysis: At least once a year, sitting down with all my tax paperwork, I see my overall finances in a way I may not think about the rest of the year. One year I noticed that this mutual fund I owned had generated a tax bill that seemed like a lot compared to the value of the account. Because I understood how taxes work for dividends and capital gains, I was able to do a meaningful analysis of my investment. I realized I could achieve the same investment goal with lower tax bills each year if I sold that tax-inefficient fund and used the proceeds to by a low-cost, tax-efficient index mutual fund. It seems like I have something like this happen nearly every year, where doing my taxes gets me thinking about some part of my financial life, leading to some kind of incremental improvement.

Financial empowerment: This is the biggie: doing my own taxes makes me feel like I’m the sort of person who knows how to handle their finances.  Empowerment is not some woo-woo thing left behind in the 1970’s. When I first did my own taxes I knew how to balance my checkbook and not much else. I had exposure to “finance” in some of my college classes in economics, but this was more about corporations and financial markets. After that long spring afternoon in college, with IRS publications and notepads spread all around, I started to read newspaper articles about personal finance and make connections to things I’d seen on my own tax return. Later I got into reading personal finance blogs, where I learned about techniques I could apply to my own situation. Bit by bit, knowledge accrues. You start to understand who knows what they’re talking about vs who is repeating something that sounds fancy but is actually stupid (you know the type…all hat and no cattle).

Some people just don’t want to bother with tax prep, and I get that, but I still think everyone should learn how taxes work.  Your life situation and the tax code change over time, and building up your knowledge lets you make good decisions along the way.