The Motley Fool Discussion Boards Previous Page Personal Finances / Credit Cards and Consumer Debt URL:  http://boards.fool.com/speleofools-rules-tax-math-101-11530214.aspx Subject:  SpeleoFool's Rules - Tax Math 101 Date:  11/16/1999  1:11 PM Author:  SpeleoFool Number:  19889 of 312185 ```Hi Fools, If you're new to the SpeleoFool's Rules series, check out my Introduction (post #18962) or Previous Rules (below). Well, it's not April 15th, but it is tax time. At least for my Rules series. I hope this doesn't come as too much of a disappointment, but my discussion of taxes is largely going to be a "punt." While I could talk all day about different tax rules and strategies, it's far too complicated a topic. Plus it has its own board. More importantly, I'm not an expert by any means. Please visit the Tax Strategies board or the IRS webpage at (http://www.irs.ustreas.gov/) for specific tax information. What I will cover in this post is how to do the math for taxes, once you know what you're up against. Previous Rules Interest Rates - post #18966 Net Worth - post #19025 Debt Priority - post #19189 Debt vs. Investing - post #19580 APR vs. APY - post #19719, #19741 (original post has math errors!) Simple Deductions One of the most common impacts of tax on finances is the deduction. The effect of deducting \$x is that you do not have to pay tax on that money. Unless you are very near the cutoff point for your tax bracket, you can generally use that number to calculate a "rebate" on your deduction. I'll use some mortgage numbers to demonstrate the effective after-tax impact of deductible mortgage interest. Mortgage APR = 7.0%, compounds monthly, I am in 28% tax bracket. 1. First calculate the APY. This is how much interest I will accumulate in one year. APY = 7.229% (see APR vs. APY Rule for how to calculate this). 2. Now, for each dollar I pay in mortgage interest, my deduction will refund \$.28 to me. In other words, I am only really paying \$.72 of each dollar (or 72%) of my interest cost. So, my after-tax APY is 72% x 7.229% = 5.205%. I now have a number I can use when deciding whether to invest or pick a debt to pay. Tax Credits and Complex Deductions Tax credits are nicer than deductions, in that you get all of your money back, at least up to some kind of limit. In general, they're a great advantage. Unfortunately, it's much harder to use a general method to account for credits. Same thing goes for more complex deductions that let you deduct up to a certain dollar limit. For example, suppose you have a school loan, but can only deduct some of the interest you pay. It may make sense for you, then, to put some money toward the school loan to lower the interest to the point where you can deduct as much as possible. If prepaying the loan will allow you to deduct all interest before the year is up, then you may want to switch your prepayments to another obligation with a higher interest rate. In cases like this, I use my spreadsheet and save several versions representing different scenarios. Keeping my eye on Net Worth will tell me which scenario is best. Capital Gains This is brand new to me, but I'm pretty sure I get it. I haven't actually cashed out any of my investments before, so I haven't been through the wringer yet. However, I believe the general idea is that short-term (held less than one year) capital gains on stock-type investments are taxed as regular income, and long-term gains are taxed at 10% (for 15% tax bracket) and 20% (for 28% bracket). Let's forget about collectibles and all that other junk for now. Anyway, being fairly solid in the 28% bracket, I assume that any short-term capital investments I make will be taxed at 28%, and long-term investments will be taxed at 20%. The math is very similar to that for simple deductions. First, calculate the APY, and then adjust by the tax factor. For instance, I used an example in an earlier Rule that had an index fund return at 7.56%. I calculated that by assuming a 10.5% return taxed at a short-term rate of 28%. 0.28 x 0.105 = 0.0756, or 7.56%. If I held such an investment for more than a year, it would be taxed at 20% and my return would be a little better (8.4%). More Complicated? OK, so what if we have to worry about variable rates and timeframes and dollar limits and a bunch of other ugliness? Well, we can solve any math problem if we beat our head up against it long enough. I do so using my gigantic budget spreadsheet. Generally, I find it easier to plug in a bunch of numbers and look at Net Worth than to try and devise a precise set of equations to fit every scenario. But keeping interest rates in mind is always a great place to start. Hope you've enjoyed these Rules. I'm nearly done, I think. I'd like to write one on Emergency Planning and perhaps a Summary, but I think that's about it. Until next time, Fool On! SpeleoFool. ``` Copyright 1996-2018 trademark and the "Fool" logo is a trademark of The Motley Fool, Inc. Contact Us