Does it make sense to pay no taxes?
I watched Monday’s presidential debate along with 84 million other people and one thing really struck me as I was listening. It was when Hillary Clinton accused Donald Trump of paying no Federal taxes and then Donald said that not paying taxes was really smart. Is avoiding taxes smart? Now, I’m not accusing Donald Trump of doing anything illegal. I assume he has many highly paid lawyers and accountants who prepare his taxes for him. While he might be pursuing some aggressive techniques to legally avoid paying taxes, I assume he is not actually committing fraud. At any rate, that’s between him and the IRS.
My question is really whether it is a good idea for the average American to avoid paying taxes. Let’s take a specific example: Let’s say, you work by the hour and your employer offers to either pay you on the books or pay you in cash off the books. This is very common in the so-called underground economy, especially in industries that are traditionally paid in cash, such as food-service, housekeeping, or landscaping. Is it smart to be paid off-book in cash and never declare any income?
Let’s ignore the legal issue for right now and instead talk about Social Security. When you retire, you expect to be able to collect Social Security benefits, right? Did you think everyone just automatically collects at their full retirement age? Did you every bother to find out how the amount of benefit is calculated? It turns out that you only get Social Security retirement benefits if you payed into the system via federal payroll taxes. The portion of your paycheck going to Social Security is called FICA. In 2016 the FICA tax is 6.2% on any income up to $118,500 for the year. Your employer also pays another 6.2% and if you are self-employed you have to pay both employer and employee portions. To get Social Security benefits when you retire, you have to get what the Social Security Administration calls “credits”. You have to receive 40 credits during your lifetime to get any Social Security retirement benefits. Each credit is received by earning more than $1,260 dollars and paying FICA taxes on it. You can earn 4 credits a year. So if you work 10 years and earn $5,040 or more each year, you have qualified for Social Security retirement benefits. Congratulations!
$5,040 per year is not that much money, right? So would it be smart to earn anything above this amount under the table and pay no tax? As an example if you earned $20,000 per year adjusted for inflation every year you were employed and you were 66 years old and had reached full retirement age, your monthly income from Social Security would be $933 per month or $11,196 annually. Not too much. Now lets say you earned the maximum of $118,500 and had earned the maximum for 35+ years. Your monthly benefit at Full Retirement Age (FRA) would be $2,639 per month or $31,668. Hey, not bad! Social Security bases your FRA benefit on your 35 years of greatest earnings. This means you need to pay into the system at a significant level to get a decent benefit back when you retire. This can become a sudden surprise to someone who was paid under the table for most of their working lives and suddenly find nothing waiting for them at retirement. If you pay little or no payroll taxes, you might get little or no Social Security when you retire.
The legal issue is also important. If you ever get examined by the IRS and they determine that you owe back taxes, you will owe 4% interest on any amount. Even worse, if you didn’t file at all, you will owe 0.5% of the unpaid taxes for each month that you didn’t file up to 25%. There is no statute of limitations if your failure to file or underpayment was deliberate. Of course your employer can also face penalties including even criminal penalties. Tax evasion is a Federal felony and conviction may send you to jail. Remember, that’s how they got Al Capone!
So maybe paying no taxes is smart if you’re as rich as Donald Trump, but for the average citizen its smart to pay what you owe. The good news is that proper tax planning can lower what you pay by legal means. But if you make money, you get to help fund the government by paying your fair share. You risk too much by not paying.