Sometimes deductions are not worth juggling.
With the federal tax return postponed until mid-May, Americans have some leeway and could come up with more things they think they should write off. But Rick Kahler, President of Kahler Financial Group in Rapid City, SD, shows us how some deductions can actually make you worse off:
Larry Light: How much is a tax deduction worth?
Rick Kahler: Maybe less than you think. There are several ways that overemphasis on deductions can lower your tax burden, but actually cost you more money than you save.
Light: Sounds threatening. What are you?
Bald: First, let’s talk about a mortgage. I hear people say, “I could pay off my mortgage, but I would lose the interest deduction.” Keep this in mind: On average, an interest deduction is worth 12 cents for every dollar paid. This means that the net outlay costs are 88 cents.
If you don’t have a mortgage, you will now pay 12 cents more in tax for every dollar you stop spending on interest – but you also have to keep 88 cents more. Reducing your net worth by a dollar to save 12 cents is not a good money decision.
Light: What if you get a raise?
Bald: Some even refuse income to avoid a higher tax bracket. A married couple with taxable income of $ 81,050 belong to the 12% tax bracket. A $ 1 increase would place them in the 22% tax bracket. Should they take the raise? Absolutely.
Those who would oppose the hike would likely expect their taxes to rise from $ 9,726 – that’s 12% of $ 81,050 – to $ 17,831, or 22%, to $ 81,051. Fortunately, tax brackets don’t work that way. The higher bracket applies only to income greater than $ 81,050. The dollar increase would be taxed at 22 cents, bringing the total tax burden to $ 9,726.22.
Light: What about retirement accounts?
Bald: Some people don’t carefully compare traditional and Roth IRAs. Bringing pension funds into a traditional IRA offers an instant deduction, but choosing a non-deductible Roth IRA and paying some taxes might make more sense.
For example, a young couple with taxable income of $ 19,900 is in the 10% tax bracket. With a good chance, your retirement income will be significantly higher. If 10% tax savings are made today, it could mean paying 12%, 15%, or even 37% when those funds are withdrawn. With a Roth IRA, this couple would pay 10% tax on their contribution today in exchange for paying zero tax on their future withdrawals.
Light: There is an aversion to turning into one red among many.
Bald: It often makes financial sense to convert some or all of the traditional IRAs into Roth IRAs. If you find yourself in a lower tax bracket today than you expected when you retire, it usually makes sense to pay lower tax on the amount converted now rather than paying higher tax later.
Light: What about municipal bonds?
Bald: Bonds issued by municipalities are tax-free. Why pay taxes on interest on corporations and US Treasuries when you couldn’t pay taxes on interest on bonds used to fund local community ventures?
Here’s why. The current average interest rate on high quality 10 year municipal bonds is 1.1%. The average interest rate on high quality 10 year corporate bonds is 2.1%. Even if you are in the highest federal tax bracket, owning the taxable corporate bond would get you 1.32% net, which is still higher than the municipal bond. It is important that you do the math before investing in tax-free municipal bonds.
Light: Such strategies that you mentioned are difficult for some people to control their minds.
Bald: Spending a dollar to save some of the taxes will only decrease your net worth. Such behavior is not in your best financial interests, although it is completely rational based on the beliefs and emotions behind it. These beliefs could include distrust of the government, a desire to punish or control the government by reducing its revenues, inaccurate assumptions about how tax brackets work, and a belief that taxing less is always the best choice.
Tax deductions only make sense if you actually need or want to spend money on deductible items such as property taxes, interest, charitable donations, or necessary business expenses. Reducing taxes by overvaluing deductions only diminishes your own financial well-being.