Let me start this article off by saying that I do not consider myself to be wealthy, by any means.  I am stuck in, what I like to call, the income “Twilight Zone”.  The income “Twilight Zone” is the income earnings range where you make too much money to be considered poor, but too little money to be well off.  “Twilight Zone” earners make too much money to receive financial aid for school, do not qualify for a lot of tax credits on their annual tax reporting, and do not qualify for a lot of specialty programs, like tax cuts, as devised by the federal government.  But, they make too little money to be able to “cash out” - meaning they cannot pay for things such as college tuition, luxury items, and big ticket items like cars and homes without a loan.  Another way to look at “Twilight Zone” earners is as the middle child in a family.  They were born too soon to be the baby of the family so they don’t get coddled - but they were born too late to be the oldest child that has every moment of their lives captured on film and whose parents remember every detail about their childhood.  In this regard, the “Twilight Zone” earner, or child, would be Jan Brady from the 1970s TV series “The Brady Bunch”.

As a Twilight Zone earner, I have been struggling for the past few years to get my tax returns down to a science so that I pretty much break even come tax season.  I don’t want to pay too much nor do I want to pay too little in taxes.  Unfortunately for me, the past few years have been misses come tax time and I have wound up owing the government a lot of money; thus, draining a large chunk of money that I’ve saved during the tax year.

This year, I took the time to answer the “why” question of my tax errors.  I have revisited both last year’s, and this year’s, taxes to determine some of my errors.  My findings were eye-opening, and disheartening, to say the least.  But, here is a takeaway of some of the tax strategy epiphanies that I walked away with.

Itemized Deductions Are Not Static

As a person that has a high income and also an owner of real estate, I tend to itemize my deductions as opposed to taking the standard deduction.  The itemized deduction allows me to lower my Adjusted Gross Income (AGI) far lower than what the Internal Revenue Service (IRS) standard deduction would do.  However, I am noticing that my itemized deduction is getting smaller and smaller.  Consequently, my AGI is not moving me into a lower tax bracket.

What I have learned is the line item amount on the Itemization tax form worksheet that allows me to write off my residential home’s interest payments is getting smaller each year.  In 2017, I was able to write off close to $21,000 in interest payments on my house.  In 2018, that amount fell down to a little under $20,000.  For tax year 2019, that amount is now down to the mid $19,000 range.  This is because as you continue to pay off the balance of your mortgage, the allocation of your monthly payments shift from the interest to the principle.  Here is a hypothetical example: each month, my mortgage payment stays at $2000 (these numbers are fictitious).  However, with each month that passes, the money is being allocated more towards the principle and less towards the interest.  So, the payments may start to look as follows:


January 2020
Principle: $700   
Interest: $1,000   
Escrow: $300

February 2020
Principle: $704   
Interest: $996       
Escrow: $300

March 2020
Principle: $708   
Interest: $992       
Escrow: $300

April 2020
Principle: $712   
Interest: $988       
Escrow: $300

May 2020
Principle: $716   
Interest: $984       
Escrow: $300

June 2020
Principle: $720   
Interest: $980       
Escrow: $300


And so it goes until you pay off the mortgage.  What this has taught me is that there is only but so many ways you can bring down your AGI before eventually you just have to start withholding a bunch of money from your paycheck.  There are other strategies you can do to bring down your salary, but if you are looking to get out of debt, you will have to come to terms with just withholding the maximum amount out of your paycheck on a routine basis and living with a smaller take-home pay.

Understand Tax Write-Off Criterias

The one epiphany that really hurt the most is the fact that some of my “proactive” tax strategies that I implemented I’ve come to realize they actually do not apply to me because I’m “too rich” to qualify for them. 

A few years ago, I figured I’d bring down my AGI by setting up an Individual Retirement Account (IRA) to contribute to.  IRAs are tax deductible and qualifying taxpayers can write the amount they contribute to this retirement account to lessen their tax burdens.  So, even though I already had a well-funded retirement account with my employer, I figured I’d open up an IRA and contribute more money to that account to further bring my salary down so that I can fall into a different tax bracket.

What I did not pay attention to was the fact that persons earning a certain amount of money were ineligible to qualify for IRA contribution deductions and I haven’t been receiving this deduction benefit, ever!  Now, I have a bunch of money sitting in an IRA that I cannot touch until I’m 57 years of age.  The benefit is that it is invested, I still get the money in about a decade and some change, and the money is protected from certain litagations.  The downside is that the money would be best suited in my pocket now, where I can have access to pay down debt and build wealth via other investment streams, and should I need to access my own money now, I will have to pay early withdrawal penalties on those funds.

The lesson I learned was to ensure the criteria for government deductions before actualizing them.

Budget for Capital Gains

The biggest tax killer for me has been the capital gains I’ve made from the sale of securities that I’ve owned.  My Sales and Other Dispositions of Capital Assets (US tax form 8949) worksheet has gotten as thick as Lindsay Lohan’s and DMX’s combined arrest records.  I’ve been trading so much online that I may as well be considered a day trader as opposed to an investor.

Did I make good money trading securities during this timeframe?  Yes.  Did I account for the short-term and long-term capital gains taxes that I’d owe on the sale of these securities?  No.

The bottom line is that I did not account for the sale of my stocks, REITs, mutual funds, and ETFs as income throughout the year.  More specifically, I did not account for the tax rate implications of short-term vs long-term investing.

When you own a security for less than a year, it is considered a short-term investment; thus, the capital gains made from these securities is taxed similar to regular wage earnings.  Short-term investing can be taxed around 40 percent of profits made off of the sale of the security.  Long-term capital gains - those securities owned for more than a year - are taxed at between 15 and 30 percent of earnings.

The lesson I learned is to track the sale of my stocks and try to approximate the amount of taxes that I’ll owe on these funds, or deduce how this will impact my Adjusted Gross Income (AGI) and tax bracket.  Then, I need to reconcile my tax withholdings from my job with the approximated taxes owed.  I will not abandon my short-term trading strategy as I like creating additional wealth where applicable.  That is the reason why I set up 2 trading accounts - one is for long-term investing, and the other is for short-term investing to grow my money faster than it would sitting in a low-interest-earning savings account.  However, I will try to do more long-term investing than short-term investing so that I do not get taxed as hard.  Until they change the tax rates on investing, I will try to take advantage of the tax-friendlier long-term investing strategy.

Conclusion

Tax codes, more specifically the United States tax codes, and the tax system can be complex and hard to understand.  But, if you want to ensure that you do not get caught up with excess outstanding taxes owed to the IRS, then you must learn as much as possible about taxes.  Seek the help of a tax professional (Tax Attorney or Certified Public Accountant) if you can afford to do so, or read up on the tax laws in your country and study the tax forms that you must complete.

I have also started tracking my earnings and deductions so that I can approximate my estimated tax obligations for the next tax cycle, which you can find here on AJSmith365.com.  I’ve put a lot of time, effort, and research into understanding how my earnings, deductions, and itemizations work that I have projected my earnings for this year, my AGI, and my expected tax obligations.  So, the next time I submit my taxes, there should be no more surprises coming from good old Uncle Sam.