This time of year, most Americans have income taxes on their minds, but some people hurt themselves financially by putting tax savings first and economic benefits second.
Here are some tax-reduction schemes that may end up costing you more than you save:
Municipal bonds
The interest paid by municipal bonds issued within your state are tax free for both federal and state. But if you are in the low 15% tax bracket, municipal bonds probably don’t make sense for you. A good quality corporate bond pays a higher interest rate, and even after taxes you’ll be money ahead. No matter what your bracket, municipal bonds won’t produce the long-term portfolio growth you’ll experience from quality stock investments.
For example, if municipal bonds pay 3% tax-free, and one-third of your income goes to taxes, that’s the equivalent of earning a 4.5% taxable rate of return. Historically, the stock market has produced far greater returns than that.
Mortgage interest
Many people are afraid to put a big down payment on their home or pay down their mortgage because they want to preserve the interest deduction. But your mortgage interest deduction may not be doing you as much good as you think. If your mortgage interest is $1,000 a month, chances are that’s saving you less than $300 on your tax return. Interest is deducted at your regular tax rate, and if your income is high, the deduction is phased out. If your interest isn’t great, you may find that the standard deduction allowed to people who don’t itemize will create almost equal tax savings.
Tax-deductible IRAs
What could be better than a tax-deductible IRA? A Roth IRA. It isn’t tax deductible, but the money you withdraw at retirement will be tax-free. With a regular IRA you’ll have to pay income tax on all withdrawals. Of course, if you are in a very high tax bracket now, and expect to be in a very low tax bracket later, a tax-deductible IRA may be your best bet. But for most people, the Roth IRA will produce superior results over the long run.