The truth about tax deductions

Tax prep costs - How much will it cost to get your taxes done

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?

More about...Taxes

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Cam
Cam
9 years ago

Great post!

I refinanced from a 30 year to a 15 year mortgage a couple years ago (eliminated pmi which offset the increase in payments). There’s not as much interest to deduct, but I will also not hand over an extra 80K in interest to the bank over the life of the loan. It’s good to see my loan balance drop by larger chunks with each payment.

chacha1
chacha1
9 years ago

“putting the label of “tax deduction” on something doesn’t magically turn that something into a good idea or must-buy”

So, so, SO true. I know a couple of self-employed professionals who justify spending thousands of dollars annually on things “for the business” that they don’t really need, just because it’s a deductible expense. It’s still cash out of pocket!

TF, Boston MA
TF, Boston MA
9 years ago

Historically, all debt interest was deductible. Why? Presumably because the debt interest brings no benefit to the borrower — it is wasted money. These days mortgage interest is all that remains deductible, but the principle remains. Interest is a drag on your personal economy, just as it is a drag on the national economy. The more you load yourself down with debt, the harder it becomes to ever get free. Only caveat — because mortgage interest is tax deductible and most consumers have tax-deferred IRAs and 401ks available, it MIGHT make sense to put retirement contributions ahead of debt repayments.… Read more »

Pat
Pat
9 years ago

Truth be told, I would rather pay taxes to the government that I at least have some say in electing, rather than paying interest to help fund some banker’s million dollar bonus.

Jennifer B
Jennifer B
9 years ago

Yes, legitimate deductions do save on your taxes. But this post could not have put it more clearly.

Spending a lot of money in order to save a little on your taxes is not the right move most of the time. It should be considered a “bonus” to the transaction, not a reason to make the transaction.

I’ve always said the same thing about hitting a higher tax bracket with increased income – sure it stinks to be paying more to the government, but that still means that you are earning more too, and isn’t that a good thing?

Bev E
Bev E
9 years ago

Does this apply to student loans? I did the math and the amount of interest I am paying is within the deduction limit. I have heard that this is good debt and that you should fund IRA, 401K, etc before focusing on paying them off. Honestly with the amount owed it would take me an extremely long time to pay them off even though I would love to be completely debt free.

leslie
leslie
9 years ago

Someone I worked with years ago told me that they bought a time share because they needed all the tax deductions they could get (I am assuming that they could deduct the interest on the loan they got at the time to buy that timeshare). All I could do was shake my head.

Pete
Pete
9 years ago

This is much better than the article earlier today about “cheating”. Thanks for a challenging article to chew on for the afternoon.

Tyler Karaszewski
Tyler Karaszewski
9 years ago

A slight tangent, but related: Can someone answer this question for me? Assume you currently don’t own a house, and have never owned a house before. You’re planning on buying a house (not because you can deduct the interest–you were going to buy it anyway). Your mortgage payment is going to be (say) $2,500 a month. Your interest (which, being that this is the very beginning of your 30-year term, is nearly the whole payment) is tax deductible. Assuming you’re firmly in the 28% tax bracket, this means that you have a deduction of 30,000/year or 2,500/month. At 28%, this… Read more »

R. Sewell
R. Sewell
9 years ago

Unless you have an unusually high interest rate on your mortgage, you are wasting money by trying to pay it off faster. You would be much better off putting the extra money into an IRA, which will earn a higher interest rate, can generate tax-free income when you retire, and is generally protected in the event of bankruptcy.

Sara
Sara
9 years ago

Ditto to Tyler’s question. I’m also interested in the answer.

Jaime B
Jaime B
9 years ago

Good article and great advice!

It reminds me of the sales that don’t always save you money – if you wouldn’t have bought it or you buy more because it’s on sale that you don’t need (like buy1 get1 1/2 off) then you’re spending more overall even if the per unit price is lower.

csdx
csdx
9 years ago

@8 Tyler, It’s going to vary a lot depending on your personal situation. First thing is to remember is that unless you’re already meeting the deduction threshold with other deductions, the first ~$5k is just offsetting what you would have gotten with a standard deduction. That said it’s relatively easy, if you just use your last tax return as a baseline (if there are any 1 time deductions, remove them). Then redo your taxes as if you were taking those deductions. Once you find the difference in refund, just adjust the number of exemptions on your W-4 to roughly match… Read more »

Financial Samuri
Financial Samuri
9 years ago

Tyler, you just simply increase the number of withholding on your payroll to get more every month as the company taxes out less taxes.

What I’ve done is just keep things as is and get whatever money back at the end of the year thx to the mortgage.

If you are in the 33-35% tax bracket, it makes all the more sense to own.

Marsha
Marsha
9 years ago

Tyler and Sara–
The irs.gov website has a calculator you can use to find out how many exemptions you should put on your W-4. You need to know what your expected income will be this year and what your total deductions will be. This is much easier than figuring it out yourself.

http://www.irs.gov/individuals/page/0,,id=14806,00.html

Suba
Suba
9 years ago

Tyler & Sara, You have to play with your W4. Here is a handy calculator from the IRS to check what-if scenarios. http://www.irs.gov/individuals/article/0,,id=96196,00.html From my personal experience with adjusting, it takes a couple of tries to get the correct adjustments. Feel free to withhold as single for higher withholding even if you are married. You can have a lot of exemptions. Right now I have 4, even though I have no kids, its just me and my husband. The personal allowances have been the best way for me. Here is the W4 http://www.irs.gov/pub/irs-pdf/fw4.pdf lot of companies now have it online… Read more »

Suba
Suba
9 years ago

Now to the original post, I think it missed on more question – Will I buy it even if I get $0 tax deduction? I we don’t buy for tax deductions and buy only based on
1) what we need
2) if we have the money to afford that
3) what else is in stake if we buy that (retirement savings vs house down payment savings)
4) Save all the receipts
5) Finally take all the deductions we are entitled for.
I think that approach will make us do the right thing? Just my 2c. Great post btw.

Hank
Hank
9 years ago

Here’s an aspect I rarely see people to take into consideration with home mortgage. For ease let’s assume the monthly P&I of a mortgage is $1,000 a month. You have to earn as an employee in 2011 around $20,160 in annual income. You need to earn enough to cover tax collection of 28% Federal, 6.7% State (United States Average), 4.2% Social Security, 1.45% Medicare. Obviously depending on your locality you may even pay more or less. The savings in taxes (Federal & State) the first year will only be around $3,210 and less every year after. So you pay $4,950… Read more »

Tyler Karaszewski
Tyler Karaszewski
9 years ago

Thanks for those IRS links (both of them)! I will definitely check that out.

bobj
bobj
9 years ago

Makes sense to me.

jennypenny
jennypenny
9 years ago

This is a great article. The idea that mortgages are inherently good because of the tax benefit is so widespread and so wrong! That doesn’t mean you should never have a mortgage. It just means you should do the math and see what is the best use of that money. For us, we have a mortgage close to 4%, so we keep it (in part because the tax deduction lowers that rate a little) and put that money toward other things that earn a higher rate of return. The “mortgage is a great tax deduction” theory helped inflate housing prices… Read more »

El Nerdo
El Nerdo
9 years ago

@ Hank I think I see where you’re going with this but with a salary of $20K/yr you don’t pay 28% federal tax! The bracket is much lower– between $8-34K it’s only 15%– that’s 15% of the *taxable* portion of your adjusted gross income, so from those $20K subtract social security, retirement, etc., for AGI, then apply deductions: roughly $3.5-4K personal exemption for each household member, and over $11K standard deduction for a married couple/$5.5K if you’re single, $7.8K for head of household, I think. Assuming a couple with a child, I don’t think they will owe any FIT, and… Read more »

Jason Mark
Jason Mark
9 years ago

Great points about never increasing cash flow expenses just to save on taxes, but I think you’re 100% wrong on the house. You’re treating your house just like your friend with the pickup truck. You said that people should try to pay off their house as soon as possible and not plan on the tax break. The tax break is only one of MANY reasons to pay as little on your house as possible. 1) Security – Every penny you don’t prepay your mortgage can be put into savings (emergency fund) 2) Earning – Right now you can get a… Read more »

Jan
Jan
9 years ago

El Nerdo is right- couple w/one child earning $20K a year will receive Earned Income credit and qualify for food stamps and free healthcare in most states. Welcome to the bottom ranks of the military!

Now I would like to know when the tax loop holes will close for small businesses to own a truck even if their business is in one place. I am tired of paying for all of these trucks!

Jon
Jon
9 years ago

@Tyler and Sara – one other option is, if you have someone in your payroll department at work who’s smart and helpful, figure out what the change you want to make amounts to per pay period, and then have them run projections on what changing exemptions in your W2 will do. I used to do this all the time, until I got it dialed in so that I was always within $100 at the end of the year. They can also set up additional dollar amount withholdings for you, usually, if you need more to go the state or local… Read more »

Caroline
Caroline
9 years ago

I work in the housing industry and the more I learn about the mortgage interest deduction, the more disgusted I get. For most lower and middle income households, the mortgage interest tax credit does not exceed the standard deduction, making it valueless. But because you can deduct up to a million dollars in interest on your first and second house, it’s a boon for the rich. Why is the government losing money in order to help people buy million dollar plus vacation houses? I do think there is a role for the government in the housing market, specifically for low-moderate… Read more »

Mike T
Mike T
9 years ago

Way to go for thinking for yourself! I appreciate it.

Another thing that is like tax deductions that bothers me is the “deductible” on insurance. When I have to pay for let’s say medication out of pocket, most people, and esp. insurance companies always say “oh its ok, that comes off of your deductible” as if the bill doesn’t need paid. Yet I still have to pay the bill!

Shari
Shari
9 years ago

Caroline #26
I agree completely. The mortgage interest deduction for me has never yet exceeded the standard deduction. Worthless. I have only one year ever exceeded the standard deduction, in a year when we had ridiculous medical expenses, even when I have student loans and two mortgages.

And on another subject,to me, there is no such thing as “good debt”. I would love to be debt-free and not have so many monthly payments! (Working on it but it is slow going)

Des
Des
9 years ago

@Caroline

+1

Gal @ Equally Happy
Gal @ Equally Happy
9 years ago

One note about the mortgage tax deduction. It actually makes your house effectively more expensive if you lose your job.

Since you have zero (or at least almost zero) income when you are unemployed, the tax deduction is meaningless. So you’re paying the full amount of your interest without getting anything back. I have several friends who overlooked this when getting a house and lost their homes after being unemployed for lengthy periods of time in the recent recession. They assumed that the cost of the monthly payment was the total payment minus the tax deduction and calculated affordability accordingly.

Lori M
Lori M
9 years ago

You have put into very clear words what I try to tell my peers, friends and clients on a regular basis. Sending this out to all of the above!! Thank you! (Payette ID – we’re practically neighbors)

Kevin M
Kevin M
9 years ago

Tyler, If you look at IRS Publication 15 – it has the tax tables in the back – just look up your current withholding from you paycheck and the correct table based on marriage status and paycheck frequency. Then figure out how much you want to be withheld (based on your comment above) and find that corresponding “withholding” number and put that on a new W-4 for your employer. http://www.irs.gov/pub/irs-pdf/p15.pdf Be careful though to only figure the difference between your new itemized deduction amounts and the standard deduction you usually get otherwise you might adjust too far. You can probably… Read more »

John D
John D
9 years ago

This is a great post. I have seen many people do this, and most of the time it just doesn’t make sense. I’m glad someone took the time to articulate it so clearly…this is an article that everybody needs to read and take the time to understand. (Especially when it comes to mortgages. I’d rather pay the government 25% of the money I saved by not paying interest to a bank. I don’t know why that’s so hard for people to understand!)

John D
John D
9 years ago

@ Jason Mark #23 – That thinking is so messed up I don’t know where to begin. First of all, you’re saying that having equity in your home is undesirable? You’re saying that it’s smarter to be leveraged so much that the bank will avoid foreclosing on you? Even if that was how banks sometimes behaved, that’s not enough reason to risk it. Personally, I don’t think banks think it through like that for individual homes. Perhaps for huge commercial multi-million dollar loans…perhaps…but not for your house. If anyone were to follow your way of thinking, they are setting themselves… Read more »

Deserat
Deserat
9 years ago

I’m happy to see that a CPA is willing to say it like it is regarding ‘spending, taxes and deductions.’ Those of us who are self-employed have quite a maze to navigate regarding taxes…..I look at it this way. I have to earn money in order to pay for that expense – the tax ramifications are not what should be the primary variable in the decision. Example: I need a computer for my business – what type of computer, what features are required, what is nice to have – what is the difference in the price – how many hours… Read more »

getagrip
getagrip
9 years ago

To me this is the same as buying something that’s “on sale”. “Look I saved XXX dollars”. Everyone forgets you typically had to spend much more than you “saved” when bragging about what a great deal they got. I recently bought a used vehicle and got a great deal on it, but I still ended up spending a lot more than I planned on spending. All my spouse could keep focusing on was how much we were “saving” under blue book value, though we were spending thousands more than originally budgeted. It wasn’t until I finally brought up that to… Read more »

Hank
Hank
9 years ago

@El Nerdo

$20K a year in income doesn’t qualify for much of mortgage. My example is to provide enlightenment to whatever tax bracket you’re in that you must earn a considerable amount more to pay what’s owed, rather it’s a mortgage or otherwise. To pay a dollar you must first earn 1.43 to 1.88 and of course gleefully take advantage of tax deductions.

Dwight Kellams, CFP, CPA/PFS, MBA
Dwight Kellams, CFP, CPA/PFS, MBA
9 years ago

This is a good explanation of “don’t let the tail wag the dog”. The tail in this case is taxes and the dog is your personal finances. I tried to talk my wife’s unmarried friend out of purchasing a home. She did it purely for the tax deduction. She changed jobs regularly and then was forced to take a job that made it difficult to afford the house. Compound this with the fact that pollutants were found in her neighborhood destroyed her property value overnight and she was left with few options. Hindsight is 20/20 but an individual that probably… Read more »

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