Americans get an 'F' in understanding taxes, study finds

The average US adult scores about 50 percent on personal finance questions related to US income tax returns, according to a recent survey. A majority of Americans do not know the tax implications of popular financial products such as Roth IRAs, flexible spending accounts, and 529 college plans.

The average U.S. adult scores about 50% on personal finance questions related to U.S. federal income tax returns, a NerdWallet survey has found. As tax day approaches, this survey highlights how consumer-unfriendly the American tax code can be.

Most American adults get an “F” in understanding income tax basics, according to a NerdWallet survey of 1,015 people across the U.S. in early February. Respondents scored on average 51% in a 10-question quiz on tax basics related to such personal finance issues as retirement, college savings and health care.

How would you score? Take the tax test here.

A majority of respondents did not know the tax implications of popular financial products such as Roth individual retirement accounts, flexible spending accounts and 529 education plans.

“The U.S. tax code confuses the average American, and that confusion can be costly,” says Shiyan Koh, general manager of NerdWallet’s Ask an Advisor. “It’s clear that consumers need to search out the best expert advice to steer through thorny tax questions that hit their pocketbook.”

For example, most survey respondents thought Roth IRA contributions are taken from pre-tax salary. Although contributions to a 401(k) retirement accounts are deducted from taxable salary, Roth IRA contributions are not. Similarly, contributions to 529 plans — legally known as “qualified tuition plans” to save for college — are not tax-deductible. But both Roth IRAs and 529 plans can qualify for tax-free growth and disbursement of funds.

Survey question: Is the money you put in a Roth IRA pre-tax or post-tax?

a. Pre-tax
b. Post-tax
c. None of the above

Answer: B. Roth contributions are never deductible, but all growth and earnings are tax-free. Another benefit to funding a Roth IRA is that you can withdraw your original contributions (called “basis”) at any time, no matter your age. You may, however, owe tax and penalties on withdrawals of any growth and income in addition to your original basis if your account is less than five years old. But, as is almost always true of the tax code, there are exceptions that could help you out.

How our survey responded:

Answer Choices	Responses
Pre-tax (sample size)	45.91% (466)
Post-tax (sample size)	41.87% (425)
None of the above (sample size)	12.22% (124)

Source: NerdWallet

Survey question: A 529 plan is:

a. A way to make tax-deductible contributions for college savings
b. A college investment plan that earns tax-free income as it grows
c. A plan that allows qualified users to defer their tax payments

Answer: B. 529 plan contributions are not tax-deductible on federal returns, but the income and use of the account are tax-free “as long as they are used to pay qualified higher education expenses for a designated beneficiary,” according to the IRS. However, some states do offer a tax break for 529 plans.

How our survey responded:

Answer Choices	Responses
A way to make tax-deductible contributions for college savings (sample size)	42.66% (433)
A college investment plan that earns tax-free income as it grows (sample size)	42.07% (427)
A plan that allows qualified users to defer their tax payments (sample size)	15.27% (155)

Source: NerdWallet

Another question that threw respondents for a loop was related to health care and day care tax benefits. With the stratospheric rise in both health care and day care costs, Americans should be more familiar with flexible spending accounts, or FSAs, says Andrew Fitch, a senior health analyst for NerdWallet.

“FSAs are set up with your employer to create tax-free accounts up to $2,550 a year to help defray medical expenses not covered by your insurance, or up to $5,000 a year for child care,” Fitch says. “Because the money is taken before taxes, not only do you have money earmarked when out-of-pocket medical expenses arise, but you also minimize your tax burden by reducing your taxable income.”

Survey question: What is a flexible spending account?

a. A tax-exempt savings account exclusively for health benefits
b. A tax-exempt savings account that allows you to make home improvements
c. A tax-exempt account for medical purposes or child care

Answer: C. A flexible spending account allows you to reduce your taxable income by saving for planned medical expenses or child care costs. It’s largely a “use or lose” savings account, as only $500 of unused cash can be rolled over into the next year.

How our survey responded:

Answer Choices	Responses
A tax-exempt savings account exclusively for health benefits (sample size)	41.38% (420)
A tax-exempt savings account that allows you to make home improvements (sample size)	11.33% (115)
A tax-exempt account for medical purposes or child care (sample size)	47.29% (480)

Source: NerdWallet

What’s tax-deductible and what isn’t?

 Another area where respondents scored low was in respect to tax deductions. This wasn’t a surprise, as deductions are notoriously difficult for the average taxpayer to understand. For example, did you know that money loaned to a relative or friend that wasn’t paid back can be deducted under capital loss rules in certain situations? Or that the costs of babysitting can be deducted if you’re out of the house doing volunteer work? Or that the costs of feeding and housing a foster pet can be claimed as a tax deduction?

“The list of deductions is exhausting and, frankly, impossible for the average consumer to know. But it’s worth analyzing your spending habits to see where you qualify for deductions,” Koh says. “This is where professional help and advice is warranted to make sure you’re getting the tax breaks you deserve while adhering to the law.”

Survey question: If you foster a pet from a nonprofit charitable organization, can you claim a tax deduction?

a. Yes, but you can only write off certain items like food, shelter and medical expenses
b. Yes, you can write off all expenses
c. False, you can’t write this off

Answer: A. If you fostered a pet from a charitable organization, you can deduct expenses such as food, shelter, medical bills and even gas mileage if you took the pet to the veterinarian. If the expenses are more than $250, additional documentation may be required.

How our survey responded:

Answer Choices	Responses
Yes, but you can only write off certain items like food, shelter and medical expenses (sample size)	44.93% (456)
Yes, you can write off all expenses (sample size)	11.13% (113)
No, you can’t write this off (sample size)	43.94% (446)

Source: NerdWallet

Survey question: If you lend money to a friend and she doesn’t pay you back, can you write it off?

a. Yes, you can write off the entire loan
b. Under certain circumstances, it can be deducted under capital loss rules
c.. No, you can’t write it off

Answer: B. The loan becomes a capital loss. You must be able to prove that the loan has become worthless and that you had not intended to make a gift. Issuing a 1099-C, the cancellation of debt form, is also a good idea.

How our survey responded:

Answer Choices	Responses
Yes, you can write off the entire loan (sample size)	5.42% (55)
Under certain circumstances, it can be deducted under capital loss rules (sample size)	41.87% (425)
No, you can’t write it off (sample size)	52.71% (535)

Source: NerdWallet

Survey question: Which of the following is tax-deductible?

a. Gambling losses
b. Sex-reassignment surgery
c. Babysitting (if you’re a parent doing charity work)
d. All of the above
e. None of the above

Answer: D. All three categories are tax-deductible. However, there are rules. For instance, with gambling losses, they cannot exceed gambling winnings. As for a sex-reassignment surgery, it cannot be purely cosmetic. And finally, parents are allowed to deduct the cost of babysitting if they volunteer at a charitable organization.

How our survey responded:

Answer Choices	Responses
Gambling losses (sample size)	7.68% (78)
Sex-reassignment surgery (sample size)	4.63% (47)
Babysitting (if you’re a parent doing charity work) (sample size)	12.91% (131)
All of the above (sample size)	39.41% (400)
None of the above (sample size)	35.37% (359)

Source: NerdWallet

But the worst mistake you can make is …

The No. 1 rule for tax season: Always file your forms. In the eyes of the IRS, it’s worse to not file taxes at all, even if you are owed a tax refund, than to file late. Most respondents, however, said owing money and not filing on time was the worst tax mistake as opposed to not filing at all.

“Failure to file taxes triggers a huge laundry list of liabilities for you, not least of which is that it can hurt your credit score,” Koh says. “Late is always better than ‘never’ when filing your taxes.”

Survey question: Which of these is the worst mistake?

a. If you owe, not filing your taxes by April 15.
b. Filing but not paying your taxes by April 15.
c. You are owed a refund, but you file late.
d. You are owed a refund, but you don’t file at all.

Answer: D. Whether you owe cash to the government or are due a refund, you should always file paperwork with the government. The worst mistake is not filing at all. There is no penalty for missing the April 15 deadline if you are owed a refund, but you’ll get your cash back even later. And if you are more than three years late, you will lose any tax refunds you were entitled to for those years.

How our survey responded:

Answer Choices	Responses
If you owe, not filing your taxes by April 15 (sample size)	49.66% (504)
Filing but not paying your taxes by April 15 (sample size)	11.33% (115)
You are owed a refund, but you file late (sample size)	2.76% (28)
You are owed a refund, but you don’t file at all (sample size)	36.26% (368)

Source: NerdWallet

Knowledge is power

One question the majority of survey respondents got right: Household exemptions and withholdings are key in determining the amount of tax taken from your salary each year.

The irony is that most Americans do nothing with that knowledge; around 75% of Americans received a refund in 2014 that averaged around $2,700, according to a U.S. Treasury audit.

“We know people enjoy getting a lump payment as a small windfall after tax season, but it demonstrates a worrisome passivity on the personal finance front,” says Koh of NerdWallet. “Essentially, Americans are willfully having more taken out of their salaries than they should and giving the U.S. government an interest-free loan in the process.”

Survey question: If your exemptions and withholdings are correct, your tax refund should be:

a. $2,500 or more
b.  $1,500 to $2,500
c.  $500 to $1,500
d. As close to $0 as possible

Answer: D. While Americans on average got a refund of about $2,700 in 2014, if your exemptions and withholdings are correct, the amount should be close to zero. Otherwise, you are giving the U.S. government an interest-free loan during the year. However, this can always vary by case. 

How our survey responded:

Answer Choices	Responses
$2,500 or more (sample size)	15.37% (156)
$1,500 to $2,500 (sample size)	10.74% (109)
$500 to $1,500 (sample size)	18.13% (184)
As close to $0 as possible (sample size)	55.76% (566)

Source: NerdWallet

Survey methodology

The survey questions were prepared with the help of tax experts from NerdWallet’s Ask an Advisor platform. SurveyMonkey surveyed 1,015 adults across the country on Feb. 4 and 5, 2015.

Full survey results are available upon request.

All respondents were 18 or older; 79% were 30 or older. Respondents were 53% female and 47% male. Generally speaking, the higher the income bracket and the older the respondent, the better the result — but no group averaged higher than 57%. More than half the respondents (53%) had households that earned between $25,000 and $125,000 a year. Roughly 20% of respondents declined to reveal their income.

Graphic by Eric M. Limaco

About NerdWallet

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