The truth about tax deductions

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Nobody likes to pay taxes. And I think we all get a little kick out of finding ways to save on our tax bill. We smile when we find a deduction we’d been missing. Maybe we think it’s a great deal because we’re sticking it to the man. Maybe the tax deduction tricks us into thinking we’re getting a discount on buying something that we want. Or maybe the tax deduction leads us to believe we’re making a smart decision. I know I get a little tingle inside when I find a new tax deduction. Don’t you?

Are All Tax Deductions Good?

The problem is that saving on taxes usually amounts to spending cash, or worse, signing up for debt. That’s right, we’re all trying to get rich slowly, and it seems like saving taxes would go hand in hand with this, but when it comes down to it, many tax deductions are really a drain on our cash flow or emergency fund. Many tax deductions can increase risk and even can put us a little bit further behind the eight ball. All in the name of saving taxes.

Related >> The Power of Positive Cash Flow

Before I lose all of you, let me say:

  • You shouldn’t pass up many tax deductions.
  • You must carefully plan in order to get tax deductions.
  • You should take advantage of almost every tax deduction you can find.

But let’s try to put tax savings in their proper place. When you spend money, you should ask yourself these questions in this order:

  1. Will this thing or expenditure increase my monthly cash flow?
  2. Does this thing or expenditure increase or decrease my net worth in five years? Related >> Net Worth: The Most Important Number in Personal Finance?
  3. Is it tax deductible?

Notice that the tax deduction question is number three on the list. It’s not nearly as important as the first two questions. I have so many customers that put tax deductibility at number one. I have some customers that sometimes forget to even think about the first two questions when they hear about number three.

Saving $10,800 in Taxes

For example, I have a young friend who owns his own small service-oriented business. He called me at the end of 2008 to talk about his $75,000 in net business income for the year. His marginal tax bracket on that net income was roughly 37%. The 37% comes from self-employment tax of 15%, Federal income tax of 15%, and State income tax of 7%.

Related >> How Marginal Tax Rates Work

I told my client that he was going to owe around $13,400 in total taxes. He asked me about buying a business truck at the end of the year that would cost him $35,000. I told him this would drop his taxes to $2,600, a $10,800 savings.

Things were tight for him. He didn’t have $13,400 saved, and he needed a new truck to make his supply runs easier. Tax savings would pay for 31% of the cost of his business truck. A no-brainer, right?

Penny Wise and Pound Foolish

The problem is $75,000 of net self-employment business income isn’t an overwhelming amount. With a home, family, taxes, and health insurance to take care of — plus the need for savings to manage the ups and downs of his business — my client bit off more than he could chew on a monthly basis.

Related >> How to Budget for an Irregular Income

Sure, he saved $10,800 in taxes that would have been due in couple of months. But to save those taxes, he decreased his monthly cash flow by having truck payments, more insurance, and more gas expense. And remember, when the vehicle is run into the ground in five years from some hard business driving, his net worth will be even less!

The smart move would have been to just pay the taxes. After the slow-down in the economy, my client was really struggling at the end of 2010, and will probably lose his business. The truck probably won’t be the final straw, but it certainly hindered the situation. When he saw the potential to save over $10,000 in taxes, his brain scrambled and his eyes glazed, and he didn’t think straight. To be honest, I might have done the same thing.

We probably all know people hurt by the downturn. In fact, you may be one of them. And I’m sure some of us bought things that we needed over the last few years for business, partly for the tax “savings”, and now we wish we had the cash back and had sent in a little tax dollars instead. Or even better, stuffed it into our retirement account.

Don’t be confused when you’re spending money on business supplies, business trips, or business equipment. Remember: You’re spending money first, and saving taxes second.

You Should WANT to Pay More Taxes

Now let’s look at a tax experience that more of us have to consider. When I look at the total income on the average tax return, I see the mortgage interest deduction and think to myself, “They don’t own their house — their house owns them.” How much of this is caused because that mortgage interest is tax deductible?

Owning a home is great, and the mortgage interest deduction is something I both like and helps us all save taxes — but don’t be beholden to it.

Related >> Why You Shouldn’t Keep a Mortgage Just for the Tax Deduction

I think of mortgage interest as the devil, not an angel. I’m working hard to get my house paid off in the next 5-7 years so I can pay more taxes. Why pay off your house early when interest is so cheap, you ask? Think about rules one and two above.

Imagine your $1400 per month house payment is costing you $1400 in cold hard cash every month. Now imagine that you can increase your monthly cash flow by $1050 a month when you get a $1400 per month house payment paid off. Your cash flow won’t increase $1400 per month because of the taxes that are being saved on the mortgage interest. But $1050 more per month in your pocket will get you ahead way faster than saving $350 per month in taxes.

Take Off the Goggles

There are some true no-brainers when it comes to tax deductions. For instance, putting 10% of your income into regular retirement accounts such as 401(k)s, IRAs, or Roth IRAs are a requirement in my book, not a tax opportunity. And tax credits and deductions for post-secondary education are just aiding an already good move. There are many more.

But remember that putting the label of “tax deduction” on something doesn’t magically turn that something into a good idea or must-buy. In fact, you have to take off your tax-deduction goggles and ask yourself if this is really getting you ahead in your financial life. Or is it saving you taxes while letting even more money slip through your hands?

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