When Tax Deductions Cost Clients Money
Advisor Perspectives welcomes guest contributions. The views presented here do not necessarily represent those of Advisor Perspectives.
How much is a tax deduction worth? Maybe less than your money scripts would have you believe. Here are some common ways that over-emphasizing deductions may reduce your clients’ tax bills but cost them more money than they save.
- Maintaining a home mortgage. "I could pay off my mortgage, but I'd lose the interest deduction." Consider this: on average, a home interest deduction is worth $0.12 for every dollar paid in interest. This means the net out-of-pocket cost is $0.88. If you don’t have a mortgage, for every dollar you no longer spend on interest you will now pay $0.12 more in taxes – but you will also have $0.88 more to keep. Reducing your net worth by a dollar to save $0.12 is not a sound money decision.
- Rejecting income to avoid higher tax brackets. A couple with a taxable income of $81,050 is in the 12% tax bracket. A $1.00 raise would put them into the 22% tax bracket. Should they take the raise? Absolutely.
Those who would turn down the raise probably assume their taxes would increase from $9,726 (12% of $81,050) to $17,831 (22% of $81,051). Fortunately, this is not the way tax brackets work. The higher bracket applies only to the earnings over $81,050. The dollar raise would be taxed at $0.22, for a total tax bill of $9,726.22.
- Not carefully comparing traditional and Roth IRAs. Contributing retirement funds to a traditional IRA provides an immediate deduction, but choosing a non-deductible Roth IRA and paying some taxes could make more sense. For example, a young married couple with a taxable income of $19,900 is in the 10% tax bracket. With a good chance their income at retirement will be considerably higher, saving 10% in taxes today could mean paying 12%, 15%, or even 37% when those funds are withdrawn. With a Roth IRA, this couple would pay 10% taxes on their contribution today in exchange for paying zero taxes on their future withdrawals.