Americans Flunk on Their Knowledge of Tax Basics

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Americans are failing -- and failing badly -- in a test released today of their knowledge of how federal income taxes work. On NerdWallet's 10-question survey of tax basics, respondents scored an average of just 51 percent, a definite "F," even on a generous sliding scale.

"I don't think we were totally surprised by what we found," said Alex McAdams, a personal finance analyst at NerdWallet. "The tax code is pretty complicated, so you can't blame people for not understanding the details." Still, many respondents did not know many basic aspects of the tax code, such as if you're married, can you file separately or do you have to file a joint tax return with your spouse? The answer: yes, you can both file separately.

The survey questions focused on personal finance issues, such as Roth individual retirement account contributions, 529 college savings plans and flexible spending accounts. "The U.S. tax code confuses the average American," according to Shiyan Koh, general manager of NerdWallet's Ask an Adviser service, "and that confusion can be costly."

See How You Do

McAdams says one of the most striking examples of how people are overwhelmed by the complexity of dealing with taxes has to do with withholdings on your paycheck. NerdWallet asked: 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

Most of the 1,015 adults responding Feb. 4-5 got it correct (you know it's D, right?) -- but most Americans fail to act on that knowledge. According to the Treasury Department, about 75 percent of tax filers received a refund last year and the average refund totaled $2,700. "That's basically money you are giving to the government as a free loan, money you could be investing," said McAdams.

He notes that you can change the withholding on your paycheck at any time. For example, if you have a child, you should adjust your withholding to take advantage of that extra deduction. "Getting to exactly zero can be tough, but when you look at the average refund size, there are adjustments that you can make to come closer to zero," said McAdams. He says the payroll or human resources department at your employer can often help you figure this out. "If you had either a really big refund or a big tax bill, you might need to change your withholding."

And Then What?

The apparent lack of financial education can be costly to taxpayers, but McAdams acknowledges that "taxes are a big beast of a thing" and the average person is not going to learn every nook and cranny of the tax code. However he says it is important to learn the implications of certain basics, such as the different treatment of contributions to Roth IRAs vs. contributions to traditional IRAs or 401(k) plans. The basic answer is that contributions to a Roth IRA are not deducted from taxable salary, while contributions to a traditional IRA or 401(k) are deductible. However, the Roth IRA has a big tax advantage down the road in that when it comes time to withdraw money from your account, that is done tax free, while withdrawals from the other accounts are taxable.

NerdWallet's survey is intended to help raise people's awareness and motivate them to learn more about tax issues, according to McAdams. He says taxes need to be a consideration throughout the year. "Any time I'm making a really big financial decision, it's going to have tax implications," he said, "so seek out advice." Ready to take the NerdWallet quiz?
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