I feel so helpless as a taxpayer, watching the ridiculous directions the senate, house and president are taking my country. Being self-employed, in the medical field and living in NY I feel like I have three strikes against me. As Emma Goldman, the famous communist said, “If voting changed anything, it would be illegal.” I am seriously considering relocating to my home state of Indiana, where Gov. McConnell seems to be making some very fiscally responsible decisions. I am, however, 58, and moving seems to be more of an issue than is was at 20. What sort of feedback do you get from other taxpayers?

Personally, I agree with Susan to a certain extent. However, my interest is mostly in local taxes, to tell the truth. I’m worried about roads. I’m worried about our local fire department. I just tend to focus locally on most of this stuff, without as much concern on the national level.

I’ll be honest: I get next to no feedback at all when it comes to taxes. On the occasions when I do get feedback about taxes, it’s usually in a form described by Susan – they’re angry at the government’s use of their taxpayer dollars.

In truth, taxes are where the rubber meets the road in terms of politics and personal finance. Without tax dollars, the government cannot run.

Few would argue that there aren’t benefits from our tax dollars. Tax dollars pay for roads, bridges, fire departments, and many other services that we simply take for granted every day.

Most would argue that some aspect of their tax dollars’ use doesn’t please them, too. There are endless arguments about public and private funding of various services that people use, and these arguments have been around since nearly the dawn of time.

But when push comes to shove and the tax bill comes due, it’s not looked at as a political issue for most people. Taxes are a bill that need to be paid – and it’s worthwhile to minimize that bill. People seek out tax deductions that are available for them, plan around tax-free holidays, and seek out ways to make purchases that avoid sales tax.

To put it simply, taxes are a personal finance matter for most people, not a political matter. They aren’t worried about where their tax dollars are going as much as they are concerned about minimizing how many dollars they pay out without getting in trouble.

Why is this? I think that for many people, the connection between going to the local polling place to vote and their wallet is too tenuous. Obviously, it exists, but for the most part, the thought processes that go into deciding who to vote for and the thought processes that go into voting are distinct. When they do overlap, it’s usually by people who see it as their goal to minimize taxation at the expense of provided services. That’s why you see tax protests but rarely see people advocating paying more taxes.

Is that a healthy solution? I’m not really qualified to say, but I do think it is a natural solution. It’s much easier to look at things from the perspective of “how does this affect me” than “how does this affect the world” when dealing with the affairs of everyday life, like paying taxes. Given the complexity of modern life, it seems that the political side of taxes is mostly focused on by people who are passionate about politics and largely ignored by people who aren’t similarly passionate.

I look at it much like I do environmentalism. Humanity’s impact on the environment is constantly in our face, from weather changes to trash along the side of the road. For some people, this lights them on fire and they focus intently on reducing their carbon footprint and minimizing their waste. For others? It’s basically a problem that doesn’t fill them with passion and they don’t worry about it too much in their day to day lives. Sure, if there’s something simple to be done, they’ll do it, but they’re not going to start living ultra-green to do it.

I think this is largely driven by the media. A few years ago, being green was “cool” and lots of people were focusing on the environment. Now, frugality seems to be “cool” (at least to some extent) and the media’s giving that attention and thus lots of people are thinking about it. In a few years, it’ll be some other cause that people can take action on with little steps and feel good about themselves for doing something positive. Maybe it’ll be taxes. Or maybe it’ll be something we don’t even foresee, like some sort of local food revolution. It’s very hard to tell.

In the end, though, taxes, for most people, are just another bill to pay. Sure, it’d be great to have a smaller bill, but if that means losing some service they rely on or value, they’re not too interested, and the details are something for people in Washington to work out.

What do you think? Are taxes just another bill to pay, or is excessive taxation something you’re interested in fighting with larger steps (like moving to another state, protesting, or getting politically involved)? I don’t think there’s really a right or wrong answer here at all.

Obviously, the big difference comes when you pay into these accounts. With a Roth IRA, you put your money in after taxes – from your take-home pay. With a 401(k), you invest with money before taxes. Thus, a 401(k) investment reduces your taxes today, while a Roth IRA investment reduces your taxes tomorrow.

Many people want a simple answer to the question of which retirement account type is better – but it’s not that simple at all. To truly know which option is the best one would require a crystal ball.

The best we can do is make the case for a future where a Roth IRA is better – and a future where a 401(k) is better. Let’s look at each one.

A Roth IRA Is Better If…
… income tax rates go up from where they’re at now. Let’s face it – the United States is deep into debt. The revenue to pay for that debt will have to come from somewhere. At the same time, income tax rates are currently about as low as they’ve been in decades. What’s a reasonable conclusion from this? The government will raise individual income tax rates gradually over time to make up for all of the rampant spending since the start of the Reagan years.

… your earnings go way up from your current level. If you have higher earnings later in life, it’s likely that most of your retirement savings will also come later in life so that you can have a standard of living in retirement that’s notably higher than what you have now. If you need a lot of money in retirement, it’ll be very useful to have some of that money arrive on your plate tax-free, especially if the income tax rates are higher. In other words, if you have a big entrepreneurial bone in your body, a Roth IRA is probably a better option.

… you have other avenues of income in retirement besides the Roth IRA. Most likely, if your income goes way up, you’re going to have investments of all kinds that earn income for you in retirement. Almost all of that will be taxable income. Again, having some of your income in a non-taxable form means substantially less taxes for you, particularly, again, if tax rates are higher.

… your employer isn’t offering matching contributions into a 401(k). If you’re self-employed or with an employer that doesn’t offer a 401(k) – or doesn’t offer any sort of 401(k) contribution matching – a Roth IRA definitely looks good in comparison, since the 401(k) doesn’t have this huge advantage.

A 401(k) Is Better If…
… income tax rates stay at the same level – or go down. Many argue that the best way to increase revenue is to actually lower tax rates, spurring on business growth. If future governments apply this philosophy, it’s likely that tax levels will either stay steady or decline.

… your earnings decline, stay the same, or only go up at a slow rate until retirement. If you’re not entrepreneurial in any way, shape, or form and you’re not interested in battling your way up the corporate ladder, your income will likely remain pretty steady throughout your life. This means you won’t bump yourself up to higher tax brackets later on and you’ll likely be in this tax bracket (or a lower one) in retirement. Thus, deferring the taxes until then is advantageous.

… your main income (besides Social Security) will be your 401(k). If your income in retirement will mostly come from your 401(k) and not from outside investments, your total tax bill will be limited significantly. You won’t have additional income pushing up your tax burden (which your 401(k) will contribute to).

… your employer offers matching 401(k) contributions. This is free money that blows away any tax benefits that might come from a Roth IRA. If your employer matches your contributions, the decision becomes pretty easy – take those matches all the way to the bank.

What About a Roth 401(k)?
Some people also have the option of a Roth 401(k), which essentially works like a 401(k) except with after-tax money. A Roth 401(k) often ends up being like a Roth IRA that gets employer matching, which means that most of the arguments in favor of a Roth IRA apply to it.

In the end, though, you need to decide for yourself where you’re headed and where you believe the government is headed. Of course, all of this is moot if you don’t start saving right now. Regardless of what you choose, you’ll lose any advantage of either choice by putting off saving while you decide. If you’re unsure, sign up for one plan or another and start contributing. If you change your mind later, switch your savings plan. But, no matter what, start saving now – don’t put it off.

Just this morning, I finished up my income taxes for 2007 (along with my estimated taxes for the first quarter of 2008), wrote a small mountain of tear-stained checks, and dropped them in the mailbox. This was my first year filing taxes with significant income earned from independent work and it was a real eye-opener.

Here are some of my collected thoughts on the income tax process.

1. TurboTax is a miracle worker. In 2007, The Simple Dollar really took off. In 2007, we bought our first house. In 2007, I sold mutual funds for the first time (to help buy the house). As a result, this year was loaded with new experiences when it comes to income taxes. Add into that the fact that my wife and I worked together on our taxes this weekend, working in shifts with the other one of us focusing on child care.

The end result is that TurboTax bailed us out. We’ve been using the bare bones version for years, so it pulled in the stuff we needed for last year, and then it walked us step by step through all of the new stuff. In the end, after several hours of typing away at the keyboard and shuffling through a mountain of papers, we ended up with a neatly filled-out tax return with all of the numbers in the right places. Even better, it got me on the right track with estimating for the future, meaning we actually had a little bit left over after a year’s worth of tax savings even after being hit with a penalty for a low estimate last year. That leftover amount’s going straight towards a student loan, as is our “economic stimulus package.”

2. Children are a splendid tax break. We have two children. Just by existing and by going to day care, they netted us $2,950 in tax credit. That’s right – almost $3,000 of our tax bill went poof because of our two children.

That obviously does not make up for their expense, but it does pay for about a third of their child care over the last year, which softened the burden. To put it simply, if you have a child, the tax system does help you out with those extra costs of parenting – and that’s nice.

3. If you’re making any sort of serious side income, pay the estimated taxes. Not only is paying it all the way along a great way to make sure you aren’t nailed with a giant tax bill at year’s end, but it also ensures you aren’t hit with a nice big fat penalty either. We were hit with a penalty for estimating way too low last year about how The Simple Dollar would grow – one year ago, I honestly had no idea how “big” The Simple Dollar would become.

The second you start getting enough income that you’re getting pretty excited about it, look into form 1040 ES and the equivalent form for your state. Don’t let it slip or else tax day will be very painful.

4. We printed out almost fifty sheets worth of paper just to mail in. That’s just plain silly, especially when most of this could be filed electronically. Even better would be a drastic simplification of the tax code – a true flat tax of some kind. The simple fact that we had to burn a good chunk of a weekend and print out fifty pages of rather confusing documentation just to meet requirements tells me there’s something wrong in the system.

So, yes, I just admitted to being in favor of a flat tax. After burning most of a weekend of lost productivity, printing out fifty sheets of paper, mailing in a bunch of documents, and paying what feels like a pretty arbitrary number in the end, I definitely can see the reasoning behind just writing down your income, taking a handful of very basic deductions, and then paying a certain percentage tax on what’s left. That sounds awful good to me.

5. Signing those checks was painful. I just watched a sizable amount of cash leave my pocket earlier today. It was painful to watch all of those check being written – all of that hard-earned money simply leave my pocket, never to return.

6. But even after all of that, I don’t really mind. When I was writing those checks, I grumbled a lot, but now that they’re in the mail and I’ve had some time to reflect on what that money really means, I don’t mind. It means public education for every child. It means streets and sidewalks and fire departments. It means local parks for my child to play in and national parks for me to look at in awed beauty. It means support for the arts, support for science, and support for people who really do need it, even if the systems aren’t perfect.

Regardless of your feelings about the things that are wrong in this country, our government does a lot that is right and it gives everyone an opportunity to work on fixing what’s wrong through voting and directly participating in the system. Much of the good that I identified does come from local government, but a lot of their funding and protection comes from up the food chain. If writing that check means my son can run down the sidewalk to the park and that some poor child is able to attend school, that’s a check I’m quite happy to write, in the end.

Whenever you buy something, then sell it for a higher value, you incur capital gains. For example, let’s say you buy a Wii at a store for $250, then sell it on eBay for $300. You’ve just incurred $50 of capital gains.

Under the United States tax code, you are required to pay taxes on capital gains. If you have held the item or asset for less than one year, it is considered a short term capital gain and you pay taxes on it equal to your normal tax rate. However, if you hold it for longer than a year, you are charged 15% tax on that amount (it’s 5% if you’re in the 10% or 15% income tax bracket).

So, let’s say that you’re making enough money so that you’re in the 28% tax bracket. If you bought the Wii and sold it a month later, you are charged short term capital gains tax on that Wii, you have to pay $14 in capital gains tax when you file your taxes. However, if you wait a year and a half after the purchase to sell the Wii, you pay only $7.50 in taxes, a savings of $6.50 on your tax bill.

It is this difference that is one of the big encouragements for long term investment. Let’s say you buy $5,000 worth of a particular stock and within six months it doubles in value. If you sell immediately (and are in the 28% tax bracket), you’re going to pay $1,400 in capital gains tax. But if you hold onto it for another six months (and it doesn’t go down), you can then sell it and incur long term capital gains tax, paying only $750. That’s $650 in savings in your tax bill.

Another note: before you figure up your final tax bill at the end of the year, you can subtract your capital losses from your capital gains. So, let’s say you bought $5,000 worth of stock and then sold it later for $4,000 – that $1,000 is considered a capital loss and is subtracted from the gain (short term losses are subtracted from short term gains and long term losses are subtracted from long term gains). This is why many people time the selling of their bad stocks to maximize their tax benefit – they may want to sell it in a particular calendar year, or hold onto it for a full year until it becomes a long-term capital loss.

What’s the story here? Uncle Sam tries to make it worthwhile for people to invest for the long term by giving people better tax rates if they do so. For investors, the “buy and hold” strategy has significant tax benefits over rapid trading of stocks.

First of all, why is it important to think about future tax rates? Yesterday’s discussion about Roth 401(k)s was a very clear illustration of this. In an effort to keep the post from turning into a political discourse, I tried to avoid any discussion about tax rates and their future by making up arbitrary ones for the present and for the post-retirement era. The result? Comments like this from Eugene:

The difference happens when you have enough money to max out the 15.5K 401K limit. If you can’t hit this limit, that means taking a tax hit on the contributions means you can put less in a Roth 401K. If your tax is 25%, the choice is between 10% in a 401K or 7.5% in a Roth IRA. Not 10% versus 10%. And yes, because multiplication is commutative, applying the 25% reduction before contribution/before growth or at widthdrawal/after growth gives you the same result.

Now you also have to consider the impact of tax bands and how money is used during retirement. While working, 401K contribution money sits ontop of your income minus deductions. During retirement, the 401K withdrawals sits ontop of social security minus deductions. I suspect for 99% of people, social security will be a much smaller amount so you end up paying less overall effective taxes during retirement.

And this valid criticism from MossySF:

Trent, you are letting the tax tail wag the dog’s body. The specific tax amount now or later is irrelvant — it’s how much you have after taxes. Paying $2800 now versus $14K later? I have no idea what is better without knowing all the details. If I have to pay more tax because I earned more, hell yes I’d pay more tax. Do not report the tax bill as the final result — report the after-tax gains.

After reading a lot of this, Luke cries out for help:

Is here not ONE example that can be used to make this scenario bullet proof? My head is spinning, but not nearly as much as the arguments that say taxes will change in the future. It’s like hitting a moving target. If someone brings to the table a discussion about Roth IRA’s and 401k’s and someone starts to tear it down because what will happen in 2043 with taxes, how can everyone get on the right page if everything is a variable?

So, is there just a simple example that spells out which one is better without getting into taxology 40-years from now and a ton of what-if scenarios?

Thankfully, Erika came to the rescue with this stellar comment:

Two things:

1. Legally, choosing between a Roth and normal 401k is not an all or nothing decision. If your employer lets you, you can contribute a bit to both (combined contributions still cannot exceed the maximum for any given year).

2. Tax rates are not terribly stable (see the graph at the bottom of the Top US Marginal Income Tax Rates, 1913–2003 page). Your tax rate, regardless of your bracket, may be much higher than it is now or it may be lower.

Combining these two points, deciding which 401k plan to contribute too depends on how you want to manage risk. If you contribute to a normal 401k, you are banking on the belief that you will pay less in taxes when you retire. If you contribute to a Roth 401k, you are banking on the belief that you will pay higher taxes when you retire.

Trying to minimize your total payed taxes is a risky business that involves predicting the future. My opinion is that you should diversify. If you contribute to both types of 401k, you will not end up paying the minimal amount of taxes, but, by paying some now and some later, you will amortize your tax burden across both your working years and your retirement years, and you will reduce the risk of your prediction of the future being wrong.

What can we learn from these comments? Future tax rates are incredibly important in determining which investment is right for you.

The problem is – we can’t predict the future. Or can we? Take a look at the data on historical income tax rates and then look at national debt as a percentage of GDP. Compare the two. Notice that income taxes are high when the national debt as a percentage of GDP is going down, and income taxes are low when the national debt as a percentage of GDP is going up. Notice also that current levels are trending upward and are also at their highest point since income taxes began (excepting World War II). This is expected given that taxes are so low, but at some point, that direction must change – it’s no different than getting your credit card in the bill each month and noticing that the debt is slowly getting closer to your salary.

Eventually, we will have the money to change the trend there, whether through smaller government or more taxes. Since both parties continue to propose plans that revolve around big government to solve our problems right now, it’s inevitable that taxes are going to head back up at some point in the next two decades. That’s the conclusion I draw, anyway.

What does that mean for my wallet? If you believe that taxes are going to eventually have to go up from where we’re at right now, then Roth IRAs and Roth 401(k)s are a very good deal, because you’ll effectively pay the low tax rate now and avoid paying the higher taxes that your future self would have to pay in a normal 401(k) plan.

What if I don’t agree with your conclusion? Many people believe that taxes will remain at the same level in perpetuity, and there’s some reasonable validity to that argument, though I don’t believe it. If that’s the case, then your taxes will probably be lower in retirement than they are right now and Roth IRAs and 401(k)s aren’t that good of a deal.

In general, when describing scenarios on The Simple Dollar, I’ll lean towards believing that I’ll be paying more taxes in the future than now, all other things being equal.

As always, I welcome comments, but please keep partisan political posturing out of it. You can state your view on the direction of America in the future, but kindly refrain from name-calling and other such hallmarks of online political discourse (I’ve read far too much of it over the last few years).

Let’s say that we have a $200,000 loan that’s fixed at that 5.875% rate over thirty years. Using the calculator over at BankRate, if we make no extra payments at all, we’ll pay a total of $226,137.30 in interest over the life of the loan. However, we’re also in the 28% tax bracket, so that means we’ll have $226,137.30 in deductions, which will save us $63,318.44 over the life of the loan, meaning we will effectively pay $162,818.90 in interest and taxes over that period.

So what happens if we pay $500 extra in principal each month? For starters, we pay off the loan much, much earlier, in just under 15 years. Nice! Over the life of the loan, we only pay $100,499.55 in interest. With that as a tax deduction in the 28% bracket, we will effectively pay $72,359.68 in interest and taxes over that period. In short, investing $500 extra a month into our mortgage will net us $90,459.22. Right now, you should realize where this is going, because you’re putting in $90,000 ($500 times twelve months times fifteen years) to only get $90,459.22 – and it’s even worse if the income tax is higher than that.

On the other hand, what happens if we put $500 a month into a 5.05% APY savings account for 15 years? I used Excel to crunch the numbers here and discovered that doing this will give me $133,912 at the end of those fifteen years. By putting that $500 a month into just an ordinary savings account, you blow away the return of putting it into your home mortgage.

The more astute folks out there will look carefully at that mortgage calculator and observe that after fifteen years without paying extra principal and instead putting that $500 into a savings account, you won’t be able to take that balance and pay off your home loan, while the other way you would have your home loan paid off. The difference is the income tax savings each year.

If you put the extra $500 into a savings account instead of against your principal, your income tax bill at the end of the year will be significantly lower than prepaying your mortgage. If you take that money you saved on income tax each year by putting the $500 a month into the savings account instead of the mortgage and put it into that savings account each year, you’ll have an extra $63,139.55 in the account at the end of the mortgage. That leaves you with a final account balance in that account of $197,051.50. You’ll only owe $142,249.76 at the end of fifteen years, so you can just write a check to pay the whole thing off and still have more than $50,000 in the bank. In fact, if you so wish, you could actually pay off the home at the end of year thirteen and still have several thousand in the account.

In short, if your interest rate is below 7% – and especially if it is below 6% – and you have willpower, you’re much better off putting mortgage prepayments in a high interest savings account or other investment than putting it in the principal of the mortgage.

After figuring things this way, our current plan is to just put our planned mortgage prepayment into Vanguard index funds (instead of HSBC Direct because we’re pretty sure we can get better than 5.05% APY over twelve or so years in index funds). We’re currently planning on double payments, so we would effectively put a payment into the mutual fund each month and then just let it grow. We never intend to prepay on our home loan; instead, we’ll just let it ride until we move on to our dream home, then sell it off at our own pace.

Yesterday, one of my fellow personal finance bloggers wrote a piece entitled What Is The War In Iraq Costing You? In it, the author makes the following statement:

According to this report of the National Priorities Project, the median income family in the United States paid $3,736 in federal income taxes in 2006. Out of this, $1,354 is spent on military expenditure and to pay the interest for debt related to military. In other words, around 36% or a little over one-thirds of the total tax paid is used for military purposes. Now, check how much your tax payment was this year and check what one third of it comes up to.

The author also points out this tool, where you can enter the amount of federal income tax you paid in 2006 and see the exact dollar amount that you’re contributing to various branches of the federal government. For example, I entered a rough number into the tool to see what kind of results I would get:

Of the $10800.00 you paid in taxes:
$2937.60 goes to the military
$2019.60 goes to pay the interest on the debt
$2257.20 goes to health care
$648.00 goes to income security
$486.00 goes to education
$367.20 goes to benefits for veterans
$280.80 goes to nutrition spending
$205.20 goes to housing
$162.00 goes to environmental protection
$32.40 goes to job training
$1339.20 goes to all other expenses

To me, the pieces of the pie do not reflect my values. From my eyes, we vastly overspend on the military and vastly underspend on paying off the national debt and erasing many of the mistakes of the last thirty years. If we made a serious commitment to pay off the national debt like the one that was in place at the end of the Clinton administration, we could support every single program that we currently support and also drastically lower taxes. It would put an extra $2,000 or so a year in my pocket, for example, or we could use some of that money to build a better health care program.

I challenge you to look at this information and decide for yourself where you think your money should go. Which of these areas is important to you and should have more money invested? Which of these areas is not as important to you and could have some fat trimmed? Remember, you’re looking at the real dollars that you are spending. This money is the money that Uncle Sam is taking out of your pocket.

Once you’ve really figured that out, support those candidates that match your views, even if they’re not popular. Don’t worry about opinion polls or what everyone else thinks or which candidates the media covers or doesn’t cover: look at all of the candidates, even those not in the Democrat or Republican Party, and find a candidate that feels the same way that you do, and then support that candidate. For me, at least, I often have tons of political buttons and materials for various candidates from parties large and small and from various political races – I don’t worry too much about their party, I worry about what they stand for and whether it matches what I believe – and more importantly, what I’m willing to stand for with my wallet.

Remember, it’s not just politics at stake, it’s your hard-earned money. If you sit back and choose not to worry about it, you’re essentially giving them permission to take thousands of dollars out of your pocket and spend it on things you don’t like. Would you let a stranger on the street do that? Then why would you let the government do that?

I am up for a promotion at work, but a coworker says that I shouldn’t try to get the job because it will put me in a higher tax bracket. Is this something I should worry about? Would I actually make less money after getting a raise?

Don’t sweat the small stuff, Annie, and go for the promotion. You will bring home more money after getting promoted, even if it does bump you into another tax bracket. Your coworker is either misinformed or is trying to convince you not to go for the promotion. Here’s why.

A Quick Primer on Tax Brackets

At the end of the year, when you do your taxes, you’re actually calculating a number called your taxable income. This is the amount of income you brought in that the government actually takes income tax out of. The higher that number, the higher tax bracket you find yourself in.

For example, let’s say you’re a single person. In 2006, the United States federal tax brackets were:
10%: from $0 to $7,550
15%: from $7,551 to $30,650
25%: from $30,651 to $74,200
28%: from $74,201 to $154,800
33%: from $154,801 to $336,550
35%: $336,551 and above

If you make $50,000 in taxable income, then $7,550 is taxed at 10%, $23,100 is taxed at 15%, and the rest, $19,350, is taxed at 25%. That means you pay a total of $9,057.50 in income tax. $40,942.50 is yours to keep.

Now, if you got a raise and made $60,000 in taxable income, then $7,550 is taxed at 10%, $23,100 is taxed at 15%, and the rest, $29,350, is taxed at 25%. Notice that there’s only one difference here: that extra $10,000 is taxed at the 25% rate, but nothing else changes. You pay a total of $11,557.50 in income tax, and $48,442.50 is yours to keep. Your raise, after taxes, is $7,500.

Understanding tax brackets can explain a few things:

Tax deductions are more lucrative for high income people than low income people. If you only have $30,000 in taxable income, you’re only paying 15% at most on your income, so sweating it out for a $2,000 deduction saves you only $300. However, if you’re in the 35% bracket, that same $2,000 deduction saves you $700. That’s a $400 difference, so the higher income people generally get more benefit from deductions.

Tax withholdings from your paycheck are based on your pay rates and the tax brackets. This information is usually supplied by the IRS and is based on your salary and the number of dependents you claim (which are deductions). This gives a thumbnail of what you’ll be taxed on so your employer can keep out an appropriate amount of money. Altering your number of deductions changes the size of the withholdings because if you claim fewer dependents, your taxable income appears to go up, and if you claim more dependents, your taxable income appears to go down.

“Extra” income is always taxed at the highest rate. Let’s say you’re in the 28% tax bracket and you happen to make an extra thousand dollars doing some consulting work. That money is taxed at 28%, so you’d better be saving 28% of it for tax day. This is often why people end up paying more on their taxes come April – they earned some extra income.

To summarize, Annie, don’t fear the tax bracket – more earnings are always better.

In short, I learned from my parents five things not to do with your tax return:

1. Buy lots of little frivolous things. Quite often, after getting a return, my parents would take the entire family out to dinner a few times. One year, they bought a Nintendo; another year, we got a giant new television when the old one was fine.

2. Get a new car. Income tax returns often meant automobile upgrades, even if the old one was still running fine.

3. Put the check directly into a checking account “for safekeeping.” This idea was heading in the right direction, except by putting it in the checking account, it didn’t earn anything, and over time it slowly was spent on all kinds of unnecessary things until it was gone.

4. Loan it to family members. Twice, the entire return was “loaned” to a family member who just simply never repaid the “loan.”

5. Have a giant party. At least one year, my parents had a giant spring party with tons of food and drink that ate almost all of their return.

Even as a child, I knew that this probably wasn’t the best way to handle your tax return, and now as an adult, I can see even more clearly what you should be doing with a tax return. Here are ten much better options for you to use your tax return on.

1. Start (or supplement) an emergency fund. Very few Americans have an adequate emergency fund – that is, a savings account somewhere that contains money that could be used for living expenses for several months in the event of a major crisis, like job loss. Sock the return away in a high interest savings account (like the one from ING Direct) and let it just sit there until disaster strikes. This way, the disaster won’t wreck your finances – you can just go withdraw the money and it’s taken care of.

2. Invest it in a mutual fund. We have a mutual fund going so we can have our dream house at some point in the future. This is a big part of our current reasoning in our house hunt – if we buy a less expensive home now, one we can easily make the 20% down payment on, we can continue to build this fund and eventually buy a much nicer home. This is a perfect option if you have a big long term goal, like a home, that’s far down the road.

3. Start (or supplement) a Roth IRA. If you need to kick retirement saving into high gear, look into starting a Roth IRA. It’s a great way to save money for retirement without any tax issues at all.

4. Seed your own business. Roll the money into things you could use to start a side business. Not only will you be able to deduct that money next year, but you’ll also lay the foundation for another income stream.

5. Put it in a 529 for your children. Use that money to lay the financial groundwork for your child’s college education. A 529 plan allows you to easily invest money with tax-free growth for educational expenses down the road.

6. Start (or supplement) a car fund. This doesn’t mean that you should go replace your car, but merely that you’re respecting the inevitable need to replace your current automobile.

7. Do a home improvement project. Roll that money right into new kitchen cabinets, a freshened-up bathroom, repainting some rooms, or a new carpet. Home improvement projects can increase the value of your home, which is especially important if you foresee a move in the coming years.

8. Make your living space more energy efficient. Replace all of your lightbulbs with CFLs, put in programmable thermostats, air seal your home, get a blanket for your water heater (if it needs one), and so forth. Doing these things all together can significantly reduce your monthly energy bill, meaning that in the long run the money you spent will become a tremendous investment with monthly dividends on your electric bill.

9. Buy an appliance that encourages eating at home. Similar to the energy efficiency idea, purchasing an appliance (like a deep freezer or a stand mixer) that can encourage you to eat at home more often will gradually reap rewards over time, as you begin to prepare food at home. A deep freezer is one of the first investments we plan on making when we have our own home, because we can prepare many meals well in advance and merely pull them out and toss them in the oven in the evening.

10. Buy individual stocks. You could even take the money and start an individual stock investment account. This is a good way to get very familiar with the stock market and individual stock investing, though it is not something I actively pursue at this point. Remember, though, that individual stock investing carries substantial risk – but has the potential for substantial reward.

The moral of the story? There are a lot of things you can do with your tax return that can set you on a strong financial path. Don’t let this little financial boon convince you to do something unwise with your hard-earned money.

Unsurprisingly, this article was written by Henry Blodget who, along with Mary Meeker, was one of the investment analysts heavily behind the dot-com boom – and he paid dearly when it went belly-up. The end result? He lost his job at Merrill Lynch in 2001 and in 2003 was was charged with securities fraud by the SEC. He’s currently banned from the securities industry for life, which leads us to his career as a writer at Slate, where he basically spends his time slamming the securities industry.

Now that we know who is writing this stuff, let’s take a closer look at it. Here’s the key paragraph, in which he “explains” why saving is a fool’s game:

How does the math work? Let’s say your T-bills return 3.7 percent. If you stash $10,000, you’ll make $370 before taxes and inflation in the first year. Taxes are assessed on the nominal gain (before adjusting for inflation) instead of the real gain, so if you’re in the 15 percent tax bracket, you’ll then pay $56 to the government—and lose about $310 of value to inflation. In other words, you’ll eke out about a $5 real gain on a $10,000 investment (an 0.05 percent return). If you’re in higher brackets, meanwhile, you’ll actually lose about 0.5 percent of value every year. The only time you’ll generate real gains is when “real” rates of return are significantly higher than 0.6 percent (as they are now). But when real rates are negative, as they were a few years ago, you’ll be losing a lot more than 0.5 percent per year.

In other words, his argument is that if you put money into a 3.7% T-bill right now (here’s my earlier article explaining what a T-bill is and how it works), you’ll basically break even in “real value” over a long period, because inflation plus taxes will eat your gains.

Problem number one is that your other options are far, far worse. Let’s say you instead stuff the cash into your mattress. With inflation at roughly 3%, if you leave that one dollar in your mattress for ten years, it will only have the purchasing power of 74 cents while if you leave it in the T-bill, that dollar will keep its real value over the ten years. Even worse is when you spend that money now. Almost every consumer purchase you make starts depreciating immediately as soon as you buy it, making the actual spending of the money quite terrible.

In other words, Blodget is using a debate technique: argument by selective observation, also known as “cherry picking.” He’s applying a set of facts to the T-bill, but not applying it to the default state, cash.

Problem number two is the way he treats the stock market:

Unlike T-bills or bank accounts, stocks compound tax free, so you won’t owe tax until you sell them (except, again, on the dividends). Yet even stocks aren’t ideal for savings. For one thing, there are those annoying bear markets: The S&P 500 is still below where it was seven years ago, even before adjusting for inflation. Then there are dividend taxes: In the 20th century, nearly half of the average 10 percent annual return on U.S. stocks came from dividends, not price appreciation, and you pay taxes on dividends every year. Lastly, there’s the absurd way that the IRS accounts for “realized gains.” Once you’re in the black on a stock or fund, current tax policy forces you to stick with it—or get socked with a capital-gains tax bill. In other words, even if your stock’s best gains are behind it, if you switch to a better stock, it might be years after paying your tax bill before you get back to even.

This is utter madness. Capital gains tax on dividends does occur, but it’s capped at 15%. In essence, you collect a dividend of $100 – money paid out to you directly by a company without you having to get rid of any of your assets – and you only have to pay $15 on it. That’s significantly lower than the income tax that you have to pay on money you earn from working; if this dividend were treated that way, you’d likely have to pay $28 of it to Uncle Sam. In short, compared to actually working for a living, stock dividends are a very tax-effective way of generating income.

Here, Blodget uses argument by generalization: income that is taxed is bad. Dividends are taxed. Thus, dividends are bad. That’s a terrific fallacy.

Problem number three is that he spends most of the article blaming the tax man for this when the real enemy of any investment is inflation. Inflation eats the majority of your gains on most investments, but it’s an invisible monster: you don’t directly see it on the balance sheet. You only see it when you go to the store and realize that your money doesn’t buy as much as it used to.

This time, Blodget uses my favorite debate fallacy, the fallacy of the general rule. “Uncle Sam takes our money via taxes. Why would he leave us broke like that? Let’s spend instead!” and thus preys upon irrational mistrust of the government in a case where the government actually does a really good job of looking out for individual investors. The truth is that Uncle Sam only takes a small portion of the pie: the real monster in the room is that of inflation, and via the Federal Reserve, Uncle Sam is doing a very good job of battling that monster. In short, Blodget has an axe to grind, and he’s using bad debate techniques to push his viewpoint.

Here’s the truth: over the long run, saving beats spending any way you look at it. You can construct situations where saving doesn’t earn huge returns, but if you use those same glasses to look at spending the money (or even stowing it away in a mattress), those other options are far, far worse. Don’t let some fool with an axe to grind convince you to spend your money irrationally.

With the tax year over, we get to see what we owe the IRS and the State in taxes. Normally we have our employers withhold amounts and send them to those entities, where they sit doing nothing. Alternatively we could withhold nothing, and instead set that money aside in (for example) and HSBC Direct account. This could potentially be a lot of money gaining interest for you, rather than sitting in the government’s coffers doing nothing.

Obviously the trick is to actually set that money aside and not spend it, and then to set aside at least the correct amount. I’m pretty sure I’d be safe using the previous year’s taxes due as a good estimate. Just wondering what you and/or your readers might think of this.

If you look at this situation with some huge blinders on, then my reader is absolutely correct. You can keep your own withholdings, invest them yourself, and then just write a check for your income tax. Look at the federal taxes withheld on your last pay stub for the previous year; you could easily earn another 2.5% on that amount for your pocket before you even write a check for taxes.

But let’s take the blinders off and realize the truth: you are opening yourself up to a huge amount of risk by doing this. How?

You’re relying on your own calculations of what you’ll need for your income tax. You could use your previous year’s amount as a guideline, but the truth is that if there are income tax changes or changes in your own income, that amount is going to change and could change drastically. If you make a mistake here, it could be a big problem come tax time.

You’re taking money that is effectively untouchable and making it easily accessible. Suddenly, that money which you couldn’t touch before is suddenly sitting there in a savings account. Thousands of dollars. Can you resist the temptation to withdraw a little for a big date, or for a new refrigerator? Suddenly, you find yourself on tax day without enough money to cover the account.

The IRS is not impressed if you “don’t have money” to pay your taxes. The penalties for messing this up are severe: the IRS isn’t a patient and friendly organization and they will go after you if you don’t have the cash to pay.

These are significant risks that you should never overlook when considering such a thing. Because of these risks, I don’t recommend following this plan; you take a situation where your taxes are covered and turn it into a situation where there is risk. Given the penalties, that risk simply isn’t worth it.