How much is a tax deduction worth?
Maybe less than your money scripts would have you believe. Here are some common ways that over-emphasizing deductions may reduce your tax bill, but actually cost you more money than you save.
1. Maintaining a Home Mortgage. “I could pay off my mortgage, but I’d lose the interest deduction.” Consider this: on average, a home interest deduction is worth $0.12 for every dollar paid in interest. This means the net out-of-pocket cost is $0.88. If you don’t have a mortgage, for every dollar you no longer spend on interest you will now pay $0.12 more in taxes—but you will also have $0.88 more to keep. Reducing your net worth by a dollar to save $0.12 is not a sound money decision.
2. Rejecting Income to Avoid Higher Tax Brackets. A couple with a taxable income of $81,050 is in the 12% tax bracket. A $1.00 raise would put them into the 22% tax bracket. Should they take the raise? Absolutely.
Those who would turn down the raise probably assume their taxes would increase from $9,726 (12% of $81,050) to $17,831 (22% of $81,051). Fortunately, this is not the way tax brackets work. The higher bracket applies only to the earnings over $81,050. The dollar raise would be taxed at $0.22, for a total tax bill of $9,726.22.
3. Not Carefully Comparing Traditional and Roth IRAs. Contributing retirement funds to a traditional IRA provides an immediate deduction, but choosing a non-deductible Roth IRA and paying some taxes could make more sense. For example, a young married couple with a taxable income of $19,900 is in the 10% tax bracket. With a good chance their income at retirement will be considerably higher, saving 10% in taxes today could mean paying 12%, 15%, or even 37% when those funds are withdrawn. With a Roth IRA, this couple would pay 10% taxes on their contribution today in exchange for paying zero taxes on their future withdrawals.
4. Avoiding Roth Conversions. Similarly, it often makes financial sense to convert a portion or all of traditional IRAs to Roth IRAs. If you are in a lower tax bracket today than you expect to be in when you retire, it usually makes sense to pay lower taxes on the amount converted now instead of paying higher taxes later.
5. Holding Municipal Bonds. Bonds issued by municipalities are tax free. Why pay taxes on interest from corporations and US Treasury bonds when you could pay no taxes on interest from bonds used to finance local municipal ventures? Here’s why. The current average interest rate on high quality 10-year municipal bonds is 1.10%. 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 net you 1.32%, which is still higher than the municipal bond. It’s important to do the math before investing in tax-free municipal bonds.
Spending a dollar just to save any portion of it in taxes only reduces your net worth. Such behavior is not in your best financial interest, even though it is completely rational based on the money scripts and emotions behind it. Those beliefs might include distrust of government, a desire to punish or control government by reducing its revenue, inaccurate assumptions as to how tax brackets work, and a script that paying less in taxes is always the best choice.
Tax deductions only make sense if you actually need or want to spend money for deductible items like property taxes, interest, charitable giving, or necessary business expenses. Reducing taxes by overvaluing deductions only reduces your own financial well-being.