Correcting some Common Tax Misconceptions
By Sam Swift, CFA, CFP®
Well, hello there. How’s that for a catchy title? You may have noticed that there hasn’t been a blog posted in several weeks now. With various work and personal travel plus some extra responsibilities around the office, I haven’t been able to put pen to paper (or fingers to keyboard, I suppose) in a longer time than I’d prefer. This is why I’d like to talk today about time management…
Just kidding. I’m the world’s foremost expert amateur on that subject, so I’ll spare you. It was tax time recently, though, and it seems there are some misconceptions even amongst otherwise sophisticated individuals that pop up every year. If you were already aware of all of these, congratulations on being well informed!
Jumping into a higher tax bracket does not mean that all of your income is taxed at the higher rate. Let’s say you are in the 25% tax bracket, but you get a nice bonus that moves you into the 28% bracket for the year. I have seen people scramble to reduce their income so they don’t bump up into the 28% bracket and when I probe deeper I realize they think all of their income will suddenly be taxed at an extra 3%. This is not true. The 25% tax bracket ends at $153,100 for a couple, so if you make $155,000 only the last $1,900 will be taxed at 28%. In fact, even though an income of $155,000 is in the 28% tax bracket, the effective income tax rate for that couple is much closer to 19.5% because they get the advantage of the lower tax brackets on a lot of their earnings. Even someone who just breaks into the highest tax bracket of 39.6% will have an effective tax rate of around 28%.
A tax deduction is not the same as a tax credit. Both of these are helpful, but they are not the same thing. A tax credit is a dollar for dollar reduction of your income taxes. In Arizona, for example, there are multiple opportunities to get state tax credits. One can donate directly to a qualifying charity that helps the working poor, for example, up to $400 per individual. In this case, I could donate that $400 and my Arizona tax bill is reduced by $400 (assuming I have a tax liability of at least $400). On the other hand, a deduction simply reduces my taxable income upon which my tax is calculated. If I deduct a $1,000 contribution to charity, that is a tax savings of around $200-250 depending on my tax rate. And the caveat there is…
An itemized deduction is only worth something if you are itemizing. Taxpayers are entitled to the standard deduction of $12,700 for a couple ($6,350 for an individual) in 2017. In a way, it reminds me of this classic scene from Seinfeld:
If you’ve ever purchased tickets for a charity event, you may see that a certain portion of the ticket cost is deductible. That’s true, but it won’t matter to you unless your total deductions exceed the standard deduction. Obviously that’s not a reason to avoid charitable contributions, but don’t assume you’ll get an automatic tax break for various types of deductions. That’s even more true for the following.
You don’t need to take out a mortgage for the tax benefits. Yes, you can claim mortgage interest payments as an itemized deduction on your taxes. As we just discussed, however, unless your interest along with other itemized deductions exceeds $12,700 as a couple (that’s equivalent to about a 4% interest rate on a $315,000 mortgage) you won’t get an actual tax benefit from it because you won’t be itemizing. I’m primarily referring to those who appear to think they are actually making money by taking on a loan here. Assuming you can itemize, the mortgage interest deduction is a nice benefit, but it really just serves to reduce your effective interest rate. If I have a 4% mortgage and I have an effective tax rate of 25%, then my effective mortgage interest is 3% thanks to the deduction. I’m still paying a 3% loan. The mortgage deduction can make taking out a loan a bit more attractive, but it is most definitely not a reason to buy a home.
The tax system can be quite complicated. Combine that with many parties with a vested interest in confusing you and the water muddies quickly. Hopefully this helps clear up a few things and just remember that the standard rule still applies even when it comes to your taxes: if it sounds too good to be true, it probably is.