I get this request all the time. “Hey Mike, I need to find more tax deductions so I don’t have to pay as much.” Depending on the person (and my mood), my response is usually a sarcastic, “You can give half of your income to charity.” Obviously, people generally don’t want to give away half their income just to save on taxes. They are looking for deductions that allow them to reduce their taxes AND keep their money. I am going to simplify the tax code for now and just look at two different types of deductions. The first group are deductions that give you a benefit in the current year and allow you to keep your money. The second group of deductions give you a tax benefit, but you lose the money.
Keep your money and save on taxes - Traditional Individual Retirement Account (IRA), Employee Retirement Plan (401k, 403b, etc.), and Health Savings Accounts.
These are your first choices when looking to save more on taxes. Retirement plan contributions will grow in your account and you will pay tax on them in the future, but hopefully at a lower tax rate. Money that you put into a health savings account can be used for medical expenses in the future and you never pay tax on it.
Spend money to save on taxes – Mortgage interest, property taxes, charitable contributions, business expenses, etc.
This group essentially covers all other tax deductions. The amount you save from these is equal to the expense times your tax rate. These deductions are items that you need to make sure you include on your tax return if you incur them, but don’t create them for the sole purpose of reducing your taxes.
Example: You pay $5,000 in mortgage interest this year and your family makes $100,000 which puts you in the 25% tax bracket. You will receive a tax benefit of 25% of the $5,000 which is $1,250.
Would you trade me $5,000 for $1,250? Probably not. That’s why you shouldn’t do things just to get a tax deduction. It doesn’t mean that you are better off financially. However, some people would rather give $10,000 to a charity of their choice than $2,500 to the federal government. To each his own.
Remember to always think about the true savings when it comes to taxes. Don’t let a deduction tempt you into spending more money than you need to. And next time you hear Joe Cool in the break room talking about how he doesn’t want to pay off his mortgage early because of the tax benefits, you can explain the true financial cost of that decision.
-Mike Zeiter, CPA/PFS
P.S. – I have overly simplified this to discuss the general calculations. The tax rules are much more complicated so please consult with a professional about your specific options around tax planning.