Alright, pop quiz: What's a $1,000 tax deduction worth to you?
That's what I've been puzzling over recently. As far as I can tell, the answer at most about $330. Assuming that I'm uber-rich and being taxed at 28%, plus that I can somehow get the deduction on my state (4%) and local (1%) taxes, a $1,000 deduction means the government won't charge me $330. Of course, the government will give me a standard deduction of about $5,000, so the first tax deductible $5,000 I spend is a complete loss for me.
Maybe I'm crazy. But given a choice between spending money and saving money, tax deductions seem like a lousy way of saving me. Now if I'm going to spent the money anyway, a 33% sale is certainly a great deal. But 67% savings (not buying the item) is significantly better than 33%.
Anyone more familiar with taxes want to correct where I'm off here?
(Why does this come up? Well, basically I've been trying to figure out a bunch of financial decisions - 401K deductions for payroll, housing implication, how to claim deductions on taxes, and the bunch. And my general impression from talking to people is that either I'm really confused about how tax deductions work, a bunch of my acquaintances aren't very good mathematicians, are both. And it's hard to decide whether something is a good deal when one doesn't know the actual price.)
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4 comments:
You know, I've come to similar conclusions in the past. Why spend money to get deductions since it is only reducing the amount of taxable income you have, thus only saving you the tax percentage you would have paid!
If you find the answer to these questions, fill me in because I am curious!
I haven't paid my US taxes since I moved down here. I think I don't even have to file, as I have been told if you make $80,000 or less and pay taxes in your country of residence, you are exempt? I suppose I should check this stuff. by the way, I didn't understand anything written in your post, and hence have nothing helpful to add. Did I bore you?
Alright. I suck at math, let that be known. But I know people who are much better at it than I. And I will go ahead and toss in a bit of Ramsey logic and from there you get to make up your own mind.
If your company doesn't match there is no point in jumping into the 401k. At your age you will see more benefit in a Roth IRA. If you put in 500 per month as a married couple for 40 years. You have put in 240k, which should hit 5.8m in 40 years. You would have only paid taxes on 240k. If you get the same growth elsewhere, 401k etc. your money is all taxable. If you get taxed @ 25% on that same value in your 401k your total taxable value of your retirement is 1.45m (most of which stolen from Ramsey's podcast today, minute 3:20)
**Disclaimer, I do not have a Roth. I am lazy and just hopped into my organization provided 457b, cuz it was easy and I'm not yet to the aggressive investing part of the Ramsey Plan.**
Trying to get deductions should almost never be the basis of your financial decisions. It is still a better to pay off your debts as quickly as you safely can, even if it means a smaller deduction. The amount you are spending on interest far out-weighs any tax benefit. That said, you always want to itemize your deductions if it ends up being higher than the standard deduction (why turn away free money?).
On the topic of retirement plans, Mike is correct. A ROTH IRA is always best for those many years away from retirement. The only exception is if your employer matches your 401k. In that case, put as much into it as they match and any extra you want to invest into the ROTH. Always take the full matched percent no matter what your situation. You just can't beat instantly doubling your money.
Now, the reason ROTH is better than a standard IRA or 401k, has to do with when you pay taxes. With either plan, you will at some point pay income tax on your contributions. With a standard retirement plan (401k included), you don't pay any taxes until you retire. The bad part is that you end up paying taxes, not only on your contributions, but also on all the interest you made. That is HUGE, since most of the money you get is really compounded interest amounting to several times what you put into the account. With the ROTH, you pay taxes now, but all the interest you make is completely tax free. There are other advantages too, but that is by far the biggest. If you are a long way from retirement, you'll end up saving thousands and thousands of dollars in taxes just by picking the ROTH over a normal IRA. This easily out-weighs any tax-bracket differences.
One last thing. You can transfer 401k funds to a ROTH at anytime. You'll have to pay income tax when you transfer the money, so the earlier the better.
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