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Having prepared quite a few tax returns for people, I have seen a large range of incomes, from those barely making it by to those who are absolutely killing it. I have also seen very unique approaches to money management as well. But a common thread I have found throughout my few years helping people with tax returns is that taxes are frustrating and hard to understand.
Taxes Are Complicated
The United States tax system is complicated. I remember the first time I went to prepare my tax return on paper, it felt like I picked up a book written in ancient Greek, and I was only able to get about 1/10th of the way done before having to bring in a translator (my old boss). I didn’t understand all the rules and calculations, and I really dreaded even thinking about doing taxes as the end of the year approached.
Then, tax software became available, and I thought my prayers were answered. Unfortunately, the software asked me a ton of question I didn’t know the answer to, and I even submitted a return that got audited at one point because I forgot to tell them about a bunch of stocks I sold. OOPS! The 1040 forms looked like a hieroglyph, and I didn’t have a clue. So I completely understand when people get frustrated with taxes. But one thing that I try to make clear to everyone I do taxes for is the tax deductions are not something to pursue just to lower your tax bill.
Tax Deductions vs. Math
When I prepare a return, I try to find every possible credit and deduction allowed by law to ensure the tax payer only pays what they owe to the IRS. Far too many people are continually overpaying their taxes because they don’t know all the deductions they are allowed, or possibly don’t keep track of expenses very well. So I am definitely NOT advocating avoiding tax deductions when you legitimately have them. What I am against is spending more money to get a deduction that gets you a bigger refund, or lowers your tax bill. The math just doesn’t add up.
Here’s an example:
You have a small business, and owe the IRS $2,500. Your effective tax rate is 25%. To get rid of that tax bill, you have to spend $10,000 more dollars in business expenses. So you decide to buy a new business car to wipe out your tax bill. WOOOHOOO! You just spent $10,000 to reduce your tax bill by $2,500.
Math Wins.
Tax Deduction Are A Bad Investment
When you look at the numbers, you realized how dumb it is to spend money just because something is “tax deductible”. It’s like pulling out a payday loan to invest in your Roth IRA. Wha?! But people do this all the time. I have had people literally ask me how much more money they need to spend so they don’t owe the IRS next year. I always say the same thing, “you are making more money, that’s a GOOD THING! And when you make more, you owe more. But it’s ALWAYS better to make more money than to owe less.” I try to show them that the tax deduction is an incentive to grow business, not an excuse to spend money when you don’t need to.
I’ll ask them the question; “If I asked you for $100 to invest, and could GUARANTEE you that I could turn that $100 into $25, would you invest it? That’s what spending just for the purpose of the tax deduction is doing with your money. So I don’t recommend it.” That usually clears up the point and helps them realize that their money is better kept with them.
Tax Deductions Are An Incentive
Tax deductions and credits are put in place, like a big ON SALE sign, by the IRS to encourage you to invest in your business, education, or wherever they want you to spend money. But it doesn’t mean you SHOULD spend money on those things.
For example; The IRS gives you a tax deduction for buying a new car for your business (you can depreciate the value of the car quicker for a new car). But I would NEVER recommend ANYONE buy a new car. Ever. Screw the “tax incentive”, it’s not worth it. Get a good, used vehicle that has a lot of life left, and that will save you thousands of dollars. You also get a deduction for paying student loan interest. LAME! Don’t do that. I still have student loans and HATE the fact that I’m still paying interest on them. That’s why one of my goals is to kill those loans this year.
Should We Consider Tax Deductions When Making Purchases?
Oh heck yes, you absolutely should consider tax deductions when making purchases. They can be like using a coupon, where you get (whatever your tax rate is) percentage off the purchase. Heck, some things you spend money on might even give you a credit, which is dollar for dollar put right back in your pocket (yes, I know I’m simplifying this, but the concept is the same).
For example; Right now, you can get the first $2,000 you spend on education right back in your pocket! If you’re pursuing a 4-year degree, you can drop a cool $2k on classes, and see that money re-deposited right back into your account when you file your tax return. So, if you were planning on going to school, but weren’t sure, DEFINITELY CONSIDER THIS!
So, What’s The Point?
The point is, don’t spend more than you normally would on ANYTHING just to get a little tax incentive. Not worth it. The math is completely backwards, and you end up spending thousands more on crap you don’t need. You should only make purchases you were planning on making, that fit within your budget, and that make sense for you. If you can make it deductible, then go ahead and make it happen, but DON’T EVER SPEND MONEY JUST TO GET A TAX DEDUCTION, EVER!
If that’s not clear enough, just shoot me an email and I’ll copy/paste that last sentence 10,000 times and paste it into the reply mail. Bolded. In 72 point font. In comic sans.
Happy taxes! 🙂
photo credit: kenteegardin via photopin cc
Good points sir! It always amazes me to see how some will spend the money simply to get the deduction. Being a business owner myself I am always looking for ways to improve our tax situation, but it would make no sense to go out and just spend money willy nilly. If we were going to buy it already, then great we get an incentive on the back end to do it, but should never be the sole reason.
It’s like finding a coupon for a jackhammer, and being like “I need this, it’s 25% off!!!” But you rent an apartment…and work at Radio Shack.
So you’re saying I shouldn’t take out a $5k loan to fund my retirement fund in order to get $$ back and offset the taxes? Damn! I wish you published this post last week! 🙂
Seriously though, great point!
LoL. That’s an interesting way to approach it, I guess. But I don’t recommend it for most people, too much risk involved there…
Yeah, taking out a payday loan for any purpose, not just to invest in an IRA, is an indicator of a severe deficit in financial smarts. For anyone who’s thinking about payday loans or is already snared in that trap, best to make a (free!) appointment with a credit counselor at a nonprofit agency to learn how to get on top of your finances!
Agreed. Payday loans for anything is usually a red flag!
This is so true! I know many who do things like this ONLY to get the deduction. I could understand if it was a credit but most people don’t understand the difference.
Charitable contributions made solely for tax deductions drive me crazy. The funniest ones are those where the people don’t even itemize!
Hahaha, I haven’t seen it on the non-itemizers yet, but I’m sure I’ll run into it. The nice thing is, I’ve been able to train my clients against this stuff, so they’re all doing pretty well 3 years later 🙂
This is so true! Of course sometimes the world lines up and you can get a tax credit for doing what you had to do anyways. A couple years back we really needed to replace the furnance (it was an old 50%ish efficient model) and lo and behold the IRS offered the much more generous $1500 tax credit, so it made us go ahead and upgrade our furnance (well that and no longer wanting $300/month gas bills in the winter). We would have upgraded regardless of the credit, that was just icing on the cake!
Nice work. I agree, credits are another story, and in rare cases I encourage spending to push it over the edge, but almost never. If it’s a need, though, no reason not to make a smart purchase and get some money back.
Couldn’t agree more. I always said that buying something for a tax deduction was a good way to get a -75% ROI on the investment. It’s one of the reasons that I don’t get why people buy more house than they can afford since they can deduct the interest!
Yup! Though i do have “too much house” by all accounts, I definitely didn’t buy it for the tax deduction 🙂 It’s a just a perk that I take advantage of, though I hate seeing how much interest goes out each month.
I have heard the “tax deduction” explanation a million times. That is usually why people think we are crazy for paying off our mortgage. “Won’t you miss the tax deduction?” NO!
Haha! That’s why you guys rock. My goal is to be mortgage free by the time I’m 40. I definitely will not miss it either!
Makes sense, and I agree that a lot of people advocate spending money to get deductions. I have sometimes paused and thought “but then aren’t you taking away from your profit?” and the answer is yes. Sometimes it makes sense, but oftentimes it’s probably promoted far more than it should be.
99.99% of the time, spending money you wouldn’t normally spend does NOT make sense.
This is why I don’t do my own taxes! My accountant saves my life.
Haha. Yea, they can be daunting, especially if you own a business.
The only thing we have to deduct is the interest on our condo. It always amazes me how many people are brainwashed into thinking that they should buy extra stuff for the deduction or keep the mortgage they could pay off in cash for the tax write offs. Wouldn’t be my choice, but to each his own I guess.
Very well explained point here. Why spend on something that will be paid extra due to tax?
I know many people who do spend $10’000 to save $2’500 on things they sort of need. The chance of them recouping the $7’500 investment is minimal and the IRS will ultimately still claim taxes from the person on the receiving end.
For some reason, basic 3rd grade math logic goes out the window when dealing with the tax code.
I am guessing that most people who tend to buy stuff “for the deduction” have a much higher marginal tax rate than the 25% example you gave. Those people also usually have way higher mortgage balances than the $250k number you suggested.
I personally agree with you, but I understand why some people are doing what they are doing.