With the federal tax return pushed back to mid-May, Americans have some leeway and might come up with more things they think they need to write off. Corn Rick Kahler, President of Kahler Financial Group in Rapid City, SD, shows us how certain deductions might actually make you worse:
Larry LumiÃ¨re: How much is a tax deduction worth?
Rick Kahler: Maybe less than you think. There are several common ways in which too much deduction can lower your tax bill, but is actually costing you more money than you save.
Light: It sounds worrying. What are they?
Kahler: First, let’s talk about a mortgage. I hear people say, âI could pay off my mortgage, but I would lose the interest deduction. Consider this: On average, a real estate interest deduction is worth 12 cents for every dollar paid in interest. This means the net cost out of your pocket is 88 cents.
If you don’t have a mortgage, for every dollar you no longer spend on interest, you’ll now pay 12 cents more in taxes, but you’ll also have 88 cents more to keep. Reducing your net worth by a dollar to save 12 cents is not a good financial decision.
Light: And when do you get a raise?
Kahler: Some even reject the income to avoid a higher tax bracket. A couple with taxable income of $ 81,050 is in the 12% tax bracket. A $ 1 increase would put them in the 22% tax bracket. Should they take the increase? Absoutely.
Those who refused the increase would likely assume that their taxes would drop from $ 9,726, or 12% of $ 81,050, to $ 17,831, or 22% of $ 81,051. Fortunately, this is not the way tax brackets work. The top bracket only applies to winnings over $ 81,050. The dollar increase would be taxed at 22 cents, for a total tax bill of $ 9,726.22.
Light: What about retirement accounts?
Kahler: Some people don’t carefully compare traditional and Roth IRAs. Contributing retirement funds to a traditional IRA offers an immediate deduction, but choosing a non-deductible Roth IRA and paying taxes might make more sense.
For example, a young married couple with taxable income of $ 19,900 is in the 10% tax bracket. With a good chance their income in retirement will be significantly higher, saving 10% in tax today could mean paying 12%, 15%, or even 37% when those funds are withdrawn. With a Roth IRA, this couple would today pay 10% tax on their contribution in exchange for zero tax on their future withdrawals.
Light: There is one aversion to converting to Roth among many.
Kahler: It often makes financial sense to convert some or all of traditional IRAs to Roth IRAs. If you are in a lower tax bracket today than you would expect to be when you retire, it usually makes sense to pay lower taxes on the converted amount now instead of paying taxes. higher taxes later.
Light: What about municipal bonds?
Kahler: Bonds issued by municipalities are tax exempt. Why pay taxes on corporate interest and US Treasury bonds when you couldn’t pay any tax on interest on bonds used to fund local municipal businesses?
Here’s why. The current average interest rate on 10-year high-quality municipal bonds is 1.1%. 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 earn 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.
Light: The strategies you mentioned are difficult for some people to understand.
Kahler: Spending a dollar just to save some of it in taxes only reduces your net worth. Such behavior is not in your best financial interest, even if it is completely rational due to the beliefs and emotions behind it. These beliefs may include mistrust of government, the desire to punish or control the government by reducing its income, inaccurate assumptions about how tax brackets work, and the belief that paying less taxes is always the best way to go. best choice.
Tax deductions only make sense if you actually need or want to spend the money on deductible items like property taxes, interest, charitable donations, or necessary business expenses. Reducing taxes by overstating deductions only reduces your own financial well-being.