In my previous work at a public accounting firm, I heard all about tax deductions. We were always searching for ways our clients could make tax deductions work for them. But what the average Joe didn’t realize is that we weren’t making up random reasons to spend money or keep a loan simply for the tax deduction. Instead, we were making strategic decisions that allowed our clients to end up in the best financial position possible.
Too often I hear from friends asking about how they can get more deductions to lower their tax bill. Unfortunately, they’re asking the wrong question. In some cases, a lower tax bill is the result of a poor overall financial situation — not smart spending. Here’s what I mean:
The Business Owner Who Wants to Spend More at the End of the Year
When you run a business, you have expenses to pay. As a freelancer, I have to pay my utility bills every month. And if I had a landlord, I’d need to pay rent every month, too. I also have optional expenses. I could buy regular printer paper, or I could purchase fancy company letterhead that costs much more.
Business expenses reduce your income and thus lower the amount of tax that you'll have to pay each year. Some ill-advised business owners take this knowledge and spend a significant amount of money at the end of the year in order to lower their tax bill. The expenses aren’t part of a bigger plan to grow revenue, reduce other expenses, or even prepay future expenses. They’re just expenses for the sake of lowering their tax bill.
Spending a dollar on business expenses to save a fraction of a dollar in taxes is absurd, but it happens more than you’d think.
Remember, tax deductions lower the income you pay tax on, but they don’t reduce the total amount of taxes that you pay. In other words, tax deductions will save you only 25 cents per dollar of deductions if you’re in the 25-percent tax bracket. Yes, these people will get to use the product or service they bought, but unless that service or product has a good use in their business, the purchase probably wasn’t a sound decision.
This doesn’t just happen with businesses, though. The following are two insane examples of how people let taxes control their decisions:
Mortgage interest is one of the more popular tax deductions. Unfortunately, few people understand how it really works. In order to deduct your mortgage interest, you have to itemize your deductions. That’s right — if you look on your tax return and see that you take the standard deduction, you’re not eligible for a mortgage-interest deduction.
Even if you do itemize your deductions and deduct your mortgage interest, the amount up to the standard deduction would have been given to you anyway. Only the amount over the standard deduction is where you receive your tax benefit.
As such, avoiding paying off your mortgage because of the deduction may not be the best approach. You’re essentially paying one dollar in interest for zero tax benefit if you take the standard deduction. And even if you itemize, you may only get a small benefit. Which would you rather have: the money you pay in interest by paying off the loan, or a portion of that money in lower taxes by keeping the loan?
Student Loan Interest
Student loan interest is another common deduction people clamor over. Some suggest that you pay off your student loans faster than you have to because they’re a tax deduction. Again, I’d rather have the whole dollar in interest I’d get to keep if I paid off my student loans quickly than the partial dollar that I'd get to keep through a tax deduction if I paid off the student loans slowly.
Many people don’t realize that you can only deduct your student loan interest if your income is below a certain level. To get the whole deduction in 2017, your modified adjusted gross income must be below $65,000 if you file individually. Even then, you can only deduct $2,500 in student loan interest.
The Bottom Line: Are Tax Deductions Good, After All?
Rather than getting excited about a tax deduction, you should instead take a look at your whole financial picture. Which would you rather have: a percentage of a dollar saved thanks to a tax deduction, or the whole dollar in the case of deductible interest payments? For business deductions, would you rather have a useless item that was 25 percent off thanks to a tax deduction, or the 75 cents, which you could spend on something useful? Answer these questions and you’ll know what to do the next time someone gives you bad advice about tax deductions.