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Some Tax Breaks Could Actually Cost You Money. Here's How to Know the Difference.

by
Gordon W. McNamee
on
7/26/2021
Some Tax Breaks Could Actually Cost You Money. Here's How to Know the Difference.

It is natural to want to save money, especially when it comes to paying taxes. Unfortunately, a lot of people assume that the tax-saving advice given to those in a different tax bracket will apply to them as well, or they continue using tax-advantaged tools that are no longer as beneficial as they once were. In both cases, their well-intended actions are actually costing them money.

Want an example? Just look at the home mortgage interest deduction. There’s no question that there was once a time it could significantly lower tax liability. Taxpayers could write off the interest paid on a mortgage, and many people used that as a reason not to pay down their mortgage, or to buy a home rather than rent, or even to worry less about getting competitive interest rates when seeking a loan.

However, as income tax rates have fallen over the last several years, the advantages of the deduction have diminished. People whose income bracket once had them paying 50% or more in taxes were able to use the deduction to have the government pay about half of every dollar that they owed in mortgage interest, but now the average American pays less than a 15% rate in federal taxes, and as a result every dollar of home mortgage interest they pay only results in 15 cents of reduced tax liability, while they’re paying 85 cents in interest.

Making matters worse, when the standard tax deduction doubled under the 2017 tax law (Tax Cuts and Jobs Act), it became a lot harder for the average taxpayer to itemize deductions like mortgage interest. The only way that expenses qualify for itemization is if the taxpayer’s out-of-pocket on deductible items is more than that doubled standard amount, and that is far more than most Americans spend. That means that the home mortgage interest deduction is no longer available to most people – and those who do spend enough to qualify for itemized deductions still only get a modest benefit. None of this eliminates the many good reasons for purchasing a home and using a mortgage to do so – it just means that people need to realize that the tax deduction is no longer one of those reasons.

Keeping the mortgage deduction in mind as an example, let’s see what other available tax deductions don’t necessarily warrant their cash-saving reputations.

One important thing to remember is that a deduction is not the same as a write-off. When an expense is eligible for a deduction it means that you are still paying for it – you are not allowed to deduct the entire expense from your income. The deduction allows you to take a percentage off of your tax liability, but you can’t take off the full amount that you spent.

Another mistake that people make is deferring taxes. They believe that holding onto their money in savings accounts like traditional IRAs or 401(k)s instead of converting to Roth versions of the same monetary tools will save them money, when in fact the opposite may be true. If there’s a good chance that you’re going to be in a higher tax bracket in the future than you are now – which is true for most people – then liquidating those funds will mean having to pay taxes on the proceedings, and they’re going to be paying a much higher rate than would be true today. Traditional IRA and 401(k) funds are taxed as ordinary income when they are cashed out – and that’s true even if the funds originally came from tax-advantaged sources like qualified dividends or capital gains. The benefits gained from originally being in a traditional IRA or 401(k) are lost if they are liquidated, while if they had been put into a taxable or Roth account they wouldn’t be.

Finally, make sure that you understand the full impact of investing in state and local government bonds before jumping into them because of a perceived tax benefit. The interest that you will earn on those bonds is definitely not taxable by the federal government, and that does offer an advantage for those who are in the highest tax bracket. But the interest rate that those tax-exempt bonds are paying is far less than what taxable bonds pay. By trying to use the same advantages that work for very wealthy people, you might be ending up with less money in your pocket.

Using tax-advantaged tools is a great idea, but what works for one person may not work for you. Contact your tax professional to make sure you understand all of the ins and outs before you make a costly decision.

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Gordon W. McNamee

Gordon W. McNamee

Gordon W. McNamee is a Certified Public Accountant (CPA) based in Rancho Cucamonga, CA. Gordon W. McNamee can assist you with your tax return preparation, payroll, accounting and tax planning needs. <br /> <br /> 2021 is Gordon W. McNamee, CPAs 38th year in the profession. As as a former IRS agent (1984 through 1987), Gordon has been in public accounting since 1987. Gordon specializes in individual, corporate, HOA, trust, estate and payroll taxes. He also prepares financial statements and provides accounting & bookkeeping services. He enjoys making his clients feel at ease while providing a personalized professional service.

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