A woman walks into a sports store and sees a $200 puffer jacket marked down to $80. She lives in a warm climate and never wears jackets, but, how could she pass up such a great deal? She could “save” $120 if she bought the jacket, right?
Should this woman buy the jacket? Would she be ‘saving money’ if she did? And what does this have to do with taxes?
Of course, no matter how much the jacket has been reduced in price, if the woman buys the jacket, she has not saved money but spent it. Buying the jacket does not put money into a savings account – quite the opposite.
Most of us have fallen into this trap, buying something we might not have needed or wanted because we were momentarily convinced that we’d found a way to save money by spending it. People use the same faulty reasoning when they use the following losing strategies to try to “save” money on their tax bills.
Losing Strategy #1: Donating to a traditional IRA to qualify for a lower tax bracket
Some people spend money on a traditional IRA because they want to qualify for a lower tax bracket. Money deposited in a traditional IRA is tax-deferred. For example, if you have a taxable income of $79K, and you put $6K into a traditional IRA, your taxable income is reduced to $73K. If you are married and filing jointly, then this reduction in taxable income takes your tax rate from 22% down to 12%. That reduces your taxes by nearly half. What a great way to ‘save’ money, you might think.
According to nationally respected tax advisors, this is a losing strategy. For one thing, the taxes on the $6K in the traditional IRA are tax-deferred, not nontaxable. When you eventually withdraw the money from your IRA, this $6K will likely have grown larger through interest. So, you will pay more taxes on the IRA later than you would save in the short-run. Saving a little money now will cost you a lot of money at a later date.
Instead of investing in a traditional IRA, look first to invest in an employer matching 401(k) retirement fund. These funds are also tax-deferred, but the fact that you are receiving employer-donated matched funds (i.e., free cash) makes them a good investment. If you don’t have this option at work, then invest in a Roth IRA instead of a traditional one.
#2 Losing Strategy: Maintaining a house mortgage so that you can qualify for the mortgage deduction
Consider this scenario: Transferring across the country for a new job, you find two homes which suit your taste. You have to decide whether to buy a cheaper house that you could pay off quickly vs. an expensive home with a full 40-year mortgage. The real estate agent may use this second losing strategy to try to persuade you to buy the more expensive home. They may say that you need to hold a mortgage because otherwise you’d be “missing out” on the mortgage tax deduction. “The mortgage tax deduction,” they may say, “saves people thousands of dollars over the term of their mortgage.”
Yes, the mortgage interest tax deduction exists, but it is not dollar-for-dollar savings. The system is designed so that you will always pay more in mortgage interest than you are saving in tax deductions. If you pay off your mortgage, you will owe slightly more taxes, but overall you will have saved a lot more money in interest than you paid in taxes.
Your grandparents may have thought they were going into an inordinate amount of debt when they took out a 4-year home loan to buy their first home early in the 20th century. Nowadays, no one thinks twice about a 40-year home loan. The amount of interest that most of us pay on these long-term loans over the 40-year term is staggering. Paying off a mortgage makes more financial sense than holding on to a mortgage for the sake of claiming the mortgage interest deduction.
#3 Losing Strategy: DIY taxes to save the money you would be paying a tax professional
Tax relief does not come by engaging in DIY (do-it-yourself) taxes, as a general rule. Unless you have a W-2 salary with no investments, a tax professional will save more money in taxes than you pay for their expertise. A tax pro will make sure you get every deduction for which you qualify. Looking at your situation from multiple angles, a tax professional will help devise a plan that makes sense in the long-term.
If you have multiple investments or income streams, own real estate, run your own business, donate to charities, or maintain several varieties of retirement funds, consider paying an income tax lawyer or specialist to save yourself money in the long run. Industry experts estimate that 2 million Americans overpay their taxes every year. The overpayment is estimated at $1 billion annually. A tax professional can ensure that you are not overpaying your taxes and give you sage advice about annuities, insurances, and inheritances, which may be outside the knowledge or scope of experience of the average consumer.