My $1,592 Tax Mistake
I made an assumption about my 2016 taxes—and it cost me.
I think of myself as a person who gets taxes right. I know how our withholdings are set. I know what our income is, I know what our bonuses are, and I know what our marginal tax rate would be if we put nothing into tax-deferred accounts. I know just how much we should put into those deferred accounts so we can maximize our tax benefit now and when we withdraw the money later. I can estimate our adjusted gross income. I know my way around capital gains.
I look forward to filing our taxes every year, so much so that I have to hold myself back from filing until March 1 so I can be sure we’re not missing any forms. I pride myself on getting this one thing, this thing that intimidates and confuses so many people, totally nailed-it right.
But this year, I got our taxes wrong.
My wrongness stemmed from an assumption, one that was so baked-in that I never thought to call it into question. With every paycheck, my husband contributes to his 401(k), and I contribute to my defined-benefit pension. Since all of these contributions serve the same purpose — funding our lives in retirement — and since “retirement contributions = tax deductible” is an idea that has been permanently seared into my brain, I assumed that all our retirement contributions, both to my husband’s 401(k) and to my pension, were tax deductible. I assumed that they came out of our checks pre-tax and that they would reduce our AGI, a number I based all kinds of other calculations on. I assumed—and never checked.
I was wrong. My pension contributions are taxed.
How much did this assumption cost? First, it meant that we had to pay tax on roughly $7,000 of pension contributions that I was assuming were pre-tax. My goal in tax planning is to keep us right around the top of the 15 percent marginal tax bracket, so this extra $7,000 was taxed in the next bracket, at 25 percent. If I had known that this $7,000 wasn’t tax deductible, I probably would have been able to lower our AGI in other ways so the $7,000 would have fallen into the 15 percent bracket.
Total cost: the extra 10 percent we paid by going into the 25 percent tax bracket, or $700.
Second, adding those pension contributions back into our taxable income affected the tax deductibility of our IRA contributions. When your MAGI (modified adjusted gross income) tops a certain limit, a portion of your $5,500 maximum annual IRA contributions becomes non-deductible. In our case, this meant paying taxes — again, at 25 percent! — on $1,620 each of IRA contributions that we had assumed we’d be able to deduct.
Total cost: $810.
Here’s the kicker: since a portion of our IRA contributions became non-tax-deductible, I assumed it would be easy to just scoop those contributions back into our post-tax accounts and get on with our lives. Another assumption! Can you guess where this went? There was no easy scooping. After spending many, many minutes on the phone with both the IRS and our IRA administrators, I discovered that not just the non-deductible portion, but also the earnings on that portion must be scooped. The non-deductible portion can move over without issue, but the earnings must be both taxed (at 25 percent) and penalized (at 10 percent for early withdrawal). Luckily, the earnings weren’t much, but the taxes and penalty could have paid for a pretty good dinner out.
Total cost: $82.
All told, my assumption cost us $1,592. What did we get for that money?
First, I received a newfound respect and appreciation for tax professionals. I will admit that I had become over-confident, even cocky, about my mastery of our taxes. Even if we had spent $500 on a professional who could have helped us correct my mistake, we could have saved at least $792. Next year, I might just swallow my pride and get an accountant.
Next, I learned to read my damn contracts. It never occurred to me to check whether my pension contributions would be tax-deferred. To the best of my ability, I won’t make that mistake again.
Finally, $1,592 bought me a healthy dose of empathy for others who mess this stuff up. Since I’ve always felt fairly comfortable with taxes and numbers in general, I assumed that people who struggled with tax planning were either a little lazy or a little incompetent. But blowing $1,592 — enough for a round-trip ticket to Australia, just FYI! — on a tax mistake makes me realize that this stuff can be complicated, even if you’re trying your best. If you’re stressed at work or you have kids to raise or you’re dealing with health issues or you’re facing any of the other million struggles that routinely come with life in 2017, I understand that tax optimization might not be first on your to-do list.
This was a lesson I particularly needed to learn. I wish I hadn’t paid $1,592 to learn it, but if it results in a lifetime of cutting other people some slack, then it might just be a bargain.