Following sound tax advice can significantly reduce your taxable income thus saving you thousands of dollars over your lifetime.
- Saving money using a 401K or a Roth IRA allows for tax-free growth for retirement.
- Choosing the right entity can save thousands of dollars in business taxes each year.
- Putting money away in an HSA can help reduce the net cost of medical expenses.
- Putting money in a 529 plan allows tax-free growth for college savings.
But not all tax advice is good financial advice. This article will describe scenarios where good tax advice doesn’t always make much financial sense.
Don’t Pay off Your Mortgage Because You Can Deduct Mortgage Interest
It may be true that you may deduct mortgage interest if you itemize but it doesn’t make much financial sense to pay more in interest to save some in taxes. For example, if you are in a 25% tax bracket then you save $25 in tax for every $100 you pay in mortgage interest.
This means you have to spend $100 just to save $25 – why not just pay no interest and pay the extra $25 in taxes? If you have the opportunity to pay off your mortgage then go ahead and pay off your mortgage. One of the largest costs in retirement is housing not taxes, so reducing housing costs by paying off your mortgage earlier makes good financial sense.
This is especially important for the years 2018 and beyond because the number of taxpayers who itemize will drop from 1 in 3 to about 1 in 10.
Give Money To Charity Because You Can Deduct It On Your Tax Return
Giving money to charity to save money on taxes falls under the same rules as paying mortgage interest. The amount of tax you’ll save is not a dollar to dollar equivalent to the amount of charitable gifts you make. This means you’ll have to pay $100 in charity to save $25 in tax if you’re in a 25% tax bracket.
The decision to give to charity should be made based on other factors like how will this charitable gift help others. If you only give to charity because you save money on taxes then you’re better off not giving to charity at all. But if you give money to charity because you want to be a good person and serve others then by all means give freely.
The new tax changes in 2018 will make charitable deductions more difficult to claim on your tax return due to the increased standard deduction and the limitation or elimination of other itemized deductions. State and local taxes are capped at $10,000 so taxpayers will have to spend well over $14,000 in mortgage interest and charitable gifts combined to even get a tax benefit. It may be beneficial to double up charitable gifts every other year to maximize the benefit.
Don’t Rush to Pay Off Student Loans Because You Can Deduct the Interest
Similar to mortgage interest, the amount of money you save in tax is not equal to the amount of interest you pay. Even worse, student loan interest is capped at $2,500 per year in student loan interest paid. For those with high student loan balances this number is exceptionally low compared to the thousands of dollars that is paid in student loan interest each year.
It gets even worse when your income rises. If you make over $65,000 a year then your student loan interest deduction is limited and when you earn over $80,000 a year you can’t take a student loan interest deduction at all. The reason why most student’s go to college in the first place is to make over $65,000 a year so capping income at these levels makes little to no sense.
What does make sense is paying off student loans as fast as possible. The savings in interest is in the thousands when you pay off a student loan in 3 years instead of making the minimum payments for 10 or even 15 years.
Even though there are tax benefits to owning a home, giving to charity, and paying off student loans you should not base all of these financials decisions on the after tax impact. Instead, make sound financial or personal decisions first and then compare the tax implications. Good tax decisions can save thousands in taxes but good financial decisions can save even more in after tax dollars.