“But it saves me on taxes!”
Sometimes, we get TOO focused on the tax consequences of a financial decision.
For example, we take on a mortgage ignoring all the interest that we’ll be paying to the bank…because at least the interest is tax-deductible. Right?
Now, I appreciate that mortgage interest is tax deductible, but I don’t carry a mortgage solely because of that tax perk.
Breaking down the math…
you’re paying 100% of that interest to a bank. Your federal tax deduction maxes out at 37% of that amount, but is probably more like 5-15%. That’s not such a great return on investment, to pay $100 and only get $5 to $15 back.
The basic math says to look at your marginal tax rate, likely 12% or 22% for the average tax payer. If you didn’t have that deduction, you’d be taxed on that amount at that marginal tax bracket. However, there’s also the standard deduction to consider. If you didn’t have mortgage interest to deduct, you’d possibly get the standard deduction anyway as a higher tax break over the rest of your itemized deductions. The standard deduction is $12,200 for singles, $24,800 for marrieds, and $18,650 for heads of household in 2020 (it goes higher if you are blind or age 65+).
The only way to see your true tax benefit is to run a comparison analysis (sometimes called a tax plan, or a “pro forma” of your next year’s taxes). You can do this with a do-it-yourself software or online service if you have a decent handle on what you’re doing, or any tax preparer should be willing to run the comparison for you for a fee (don’t ask or expect this for free). If a tax preparer says they can’t do it all, find a new tax preparer.
I have a mortgage, but I’m not hanging onto it any longer than I need to, just for the sake of the tax benefits.
Another example is business expenses. Some business owners run around looking for places to spend money on business expenses so they can reduce their taxable income.
Now I will certainly agree that taxes are unpleasant to pay, especially self-employment taxes.
But again, we’re spending 100% of that money (be it $10 or $10,000) for only a percentage back in taxes. I’d better be getting some other benefit (like a valuable addition to my business) than just the tax perk.
Now there are times when finding these business expenses are genius moves. Tax laws allow for some legitimate and very creative deductions. If the spend adds value to your business or increases your revenue—fantastic! Spend that money and reap the tax perks!
But let’s stop doing things JUST for the tax break.
Reach out to me if you’d like to hire me for a tax planning analysis of a particular situation.