When the federal tax return moves to mid-May, Americans have room to breathe and could come up with more things they think they should write off. But Rick Kahler, president Kahler Financial Group in Rapid City, SD, shows us how some deductions could really jeopardize your condition:
Larry Light: How much is a tax deduction worth?
Rick Kahler: Maybe less than you believe. There are a few common ways that overemphasizing deductions can reduce your tax bill, but it actually costs you more money than you save.
Light: Sounds sinister. What are they?
Kahler: First, let’s talk about a home mortgage. I hear people say, “I could repay the mortgage, but I’d lose the interest deduction.” Consider this: on average, the home interest deduction is worth 12 cents for every dollar paid in interest. This means that the net out-of-pocket cost is 88 cents.
If you don’t have a mortgage, for every dollar you no longer spend on interest, you’ll now pay 12 cents more in taxes – but you’ll also have 88 cents more to keep. Reducing the net worth by the dollar to save 12 cents is not a good decision.
Light: What when you get a raise?
Kahler: Some even deduct income to avoid a higher tax bracket. The couple with a taxable income of $ 81,050 is in the 12% tax bracket. An increase of $ 1 would put them in the 22% tax bracket. Should they raise? Absolutely.
Those who would refuse the raise are likely to assume that their tax will increase from $ 9,726 – that’s 12% from $ 81,050 – to $ 17,831, or 22% of $ 81,051. Fortunately, this does not work in tax brackets. The higher grade only applies to earnings greater than $ 81,050. An increase in the dollar would be taxed at 22 cents, which would amount to $ 9,726.22.
Light: What about retirement accounts?
Kahler: Some people do not carefully compare traditional and Roth IRAs. Contributing to pension funds to a traditional IRA provides an immediate deduction, but choosing a Roth IRA without a deduction and paying some taxes might make more sense.
For example, a young married couple with a taxable income of $ 19,900 is in the 10% tax bracket. A good chance that their retirement income will be significantly higher, saving 10% in taxes today could mean paying 12%, 15% or even 37% when those funds are withdrawn. With the Roth IRA, this couple would pay a 10% tax on their contribution today in exchange for paying zero tax on future withdrawals.
Light: There is an aversion among many to turning into Roth.
Kahler: It often makes financial sense to convert part or all of a traditional IRA into a Roth IRA. If you are in a lower tax bracket today than you expect when you retire, it usually makes sense to pay a lower tax on the amount now converted, instead of paying higher taxes later.
Light: What about municipal bonds?
Kahler: Bonds issued by municipalities are tax-free. Why pay interest tax on corporate and U.S. Treasury bonds when you couldn’t pay interest tax on bonds used to fund local municipal ventures?
Here’s why. The current average interest rate on high-quality ten-year utility bonds is 1.1%. The average interest rate on high-quality ten-year corporate bonds is 2.1%. Even if you are in the highest federal tax bracket, owning a taxable corporate bond would yield you 1.32%, which is still more than a utility bond. It is important to calculate the math before investing in non-taxable utility bonds.
Light: Such strategies that you mentioned are difficult for some people to think about.
Kahler: Spending a dollar just to save any part of it in taxes only reduces your net worth. Such behavior is not in your best financial interest, although it is completely rational based on the beliefs and feelings behind it. These beliefs may include distrust of government, a desire to punish or control the government by reducing its revenues, incorrect assumptions about how tax frameworks work, and the belief that paying less tax is always the best choice.
Tax breaks only make sense if you really want or want to spend money on deductible items like property taxes, interest, charitable donations, or necessary business expenses. Reducing taxes by overestimating the deduction only reduces your own financial well-being.