It is really odd how people let taxes have such a massive impact on their financial decisions. People will flock to the stores for a sales tax holiday even though they are only saving about 10%, while a 20% off sale won’t draw much interest. Some stores have caught onto this, saying that they’ll “pay the tax” for purchases knowing that people would think they were getting a great deal.
Shopping just because it is tax-free isn’t the worst financial mistake people make, however. Here are some other boneheaded decisions many people make to avoid taxes you should avoid.
1. Keeping the home mortgage to get the tax deduction. First of all, this only works if you itemize, and for many people the standard deduction is the better deal economically (not to mention the time and hassle it saves when filling out your taxes). Secondly, most people are only saving 15 to 25 cents on the dollar. This means you’re paying $10,000 in interest each year to save $1500 to $2500. If you think this is a great idea, feel free to just pay off your mortgage and then send $10,000 to me each year. I’ll happily send back a check for $2500. Note you could get the same tax break sending $10,000 to charity each year instead of to the bank.
2. Limiting retirement investments based on IRA and 401K limits. If you are starting at age 20, putting away money up to the limits on an IRA will provide more than enough income in retirement, let alone maxing out your 401k account contributions. If you are starting at 45 or 55, however, it may not be enough. Figure out how much you’ll need in retirement based on your income needs, figure out how much you need to invest to get there using an investment calculator, and then put away extra money in a taxable account once you max out your IRA and 401k contributions if needed. A good rule-or-thumb is that you’ll need at least 25 times your expected yearly income requirements, plus a half million dollars for medical expenses. For a $50,000 per year income, that’s $1.75 M to $2 M. Put away $3 M and you’ll be able to take more risks and increase your income to buy some luxuries.
3. Buying municipal bonds for the tax savings. Sometimes it does make sense for some individuals to buy municipal bonds. For example, if you are in the top tax bracket and are buying bonds for interest income, you might do better after taxes with municipal bonds than you will with corporate bonds, even with the lower interest payments. If you don’t need the income, however, it is foolish to buy municipal bonds when they are tax-free instead of buying equities (stocks) since over long periods of time you’ll make five times the rate of return with equities than you will from municipal bonds, even with the tax savings.
So don’t always look for the tax break. Sometimes it is worth paying the taxes.
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Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.