Wednesday, December 19, 2007

The Most Popular Stupid Tax Strategy

The Most Popular Stupid Tax Strategy
Suze Orman

I know this may sound like heresy, but the mortgage interest deduction is the most overrated tax strategy in existence. I constantly hear happy homeowners boasting about how much money they “saved” with their mortgage interest deduction. Folks, you are really not saving a dime.

If you are in the 30 percent tax bracket each dollar you pay in interest is only going to “save” you 30 cents. So let’s do the math together: that means you are still spending 70 cents to save 30 cents. Please explain to me what is so great about that.

And you’re so happy with this so-called tax break you aren’t thinking clearly about what is really happening. In the first years of a mortgage the majority of your payment goes toward paying your interest on the loan, not the principal. And homeowners think that’s fine and dandy; it means a bigger tax deduction. But if you can bring some logic to this you would realize you’re not building up any equity because of your payments. You may be building up equity yes, but that is because real estate prices are going up. The question has to be asked, what happens if they ever start to go down? But let’s just look at why the mortgage companies really have you pay the majority of the interest up front. First, the stats show that homeowners tend to move every six or seven years. So that means when you go to sell you’ve only paid interest on your mortgage; you haven’t really paid down any of your principal which means that the lender has been getting interest on almost ALL of the money they originally lent you which in the long run makes them more money but at your expense.

Now while I know most people need a mortgage in order to purchase a home, there will come a time in your life when it will make sense to get rid of your mortgage. So I don’t want you to just keep paying a mortgage under the guise that it is your only tax write-off. A long time ago, I learned to do what the rich people do; very few seriously rich people have a mortgage. They simply write a check. And an interesting tax fact is that did you know that if you buy a primary residence and you have to mortgage it, that any interest on a mortgage above $1.1 million cannot be written off. You read that right, mortgage interest is only deductible up to a $1.1 million dollar mortgage.

My advice: Once you live in a house that you intend to stay in for the rest of your life, do everything you can to pay off the mortgage ahead of time. Yes, you will lose your tax write-off, but now you understand it’s really just a phantom value. And in return for paying off the mortgage ahead of schedule you will save tens of thousands of real dollars in interest you never have to pay. That sure sounds like a good deal to me.

And don’t worry about having to find oodles of money to make those extra payments. Make just one extra payment a year and you will slice 5.3 years off of your 30-year 6 percent mortgage.

Payoff Tip: Lately the buzz has been simply to set up a bi-weekly mortgage payment plan with your current lender and you will shave years off your mortgage. Bi-weekly means that you pay your mortgage every two weeks rather than once a month. To set up that bi-weekly payment plan, many of your banks will charge you $35, plus a $5 fee charged with each payment. That’s a waste of money, since you can easily do this on your own. Simply divide your current mortgage payment by 12 and send that extra amount with your current mortgage payment every month and you will accomplish the same thing. And by the way if you think those bank fees don’t add up. If you invested that $350 along with the $10 a month over 25 years and earned 8 percent you’re talking about $11,500. That is a lot to pay a lender to do something that you can do on your own.

The Second Most Popular Stupid Tax Strategy

Leasing a car makes no sense. It’s the same problem as the mortgage interest deduction. For every dollar you spend you are “saving” 30 cents (assuming you’re in the 30 percent tax bracket.) So let’s review this one more time: why are you so excited about paying 70 cents to save 30 cents? And don’t get me started on all the other problems with leasing, such as the costs for exceeding the mileage limit, or getting a dent or two, let alone addressing what happens if you cannot make the lease payment and you have to turn the car back in. In future columns I will address why in my opinion leasing is the stupidest thing most of you will ever do in your life.

Refunds Are a Sign You Have Screwed Up

Tax refunds are not gifts. It is literally a refund of money you paid. More to the point: it’s a refund of money you overpaid. You’re excited about getting a refund when in reality you’re simply getting money back from Uncle Sam that you needlessly forked over. You gave Uncle Sam an interest free loan. I don’t think you would give your own uncle an interest-free loan, so why are you giving it to Uncle Sam? And don’t tell me it’s your way of saving money. I know about your type. You get the refund check and instead of investing it, you spend it as if it’s funny money. Come on guys, let’s get a grip. If you receive a refund you need to either contact your employer’s payroll department and increase your withholding (so less is taken out of each paycheck for taxes) or if you’re self-employed, adjust your quarterly estimated tax payments. And if you think that cannot make a difference I am here to tell you it can. The average return is $3,000. What if you took that $3,000 or $250 a month and used that money to fund your Roth IRA each month? As I showed you above, that adds up to serious money over time. Now that is what is called retirement planning, not just tax tips.

Capital Gains Tax

I’d also like you to think strategically if you have any assets you plan to sell in the coming years. Remember that the 2003 tax bill lowered the capital gains rate for many of us to 15 percent. (It’s 10 percent for those in lower income brackets.) That’s a nice decrease from the former 20 percent rate. But remember that right now that break is only good until 2008; if Congress doesn’t act to keep it in place after 2008 we could see the cap gains rate shoot back up. So if you’re sitting on a big capital gain, be strategic. That five percentage point difference can add up to big savings.

Okay my friends, those are the main tips to leading a tax-smart life. Follow this advice and I guarantee it will provide you far more financial security than any annual deduction-chasing, tax-credit-searching exercise.

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