Some tax-cutting strategies make good financial sense. Other tax strategies are simply bad ideas, often because tax considerations are allowed to override basic economics.
Here’s one example of the tax tail wagging the economic dog.
Let’s say that you run an unincorporated consulting business. You want some additional tax write-off, so you decide to buy $10,000 of office furniture that you don’t really need. If you’re in the 28% bracket and you deduct the entire cost, this purchase will trim your tax bill by $2,800 (28% of $10,000). But even after the tax break, you’ll still be out of pocket $7,200 ($10,000 less $2,800) — and stuck with furniture that you don’t really need.
There are other situations in which people often focus on tax considerations and ignore the bigger financial picture. For example:
- Someone increases the size of a home mortgage, solely to get a larger tax deduction for mortgage interest.
- A homeowner hesitates to pay off a mortgage, just to keep the interest deduction.
- Someone turns down extra income, because it might push them into a higher tax bracket.
- An investor holds an appreciated asset indefinitely, solely to avoid paying the capital gains tax.
As a general rule, the best tax strategies are those that generate a deduction and leave you in control of your money.
This is what happens, for example, with IRAs, 401(k)s, and other retirement plans. Strategies that result in tax deferral can also be desirable, since you get to pay your tax bill years from now in usually cheaper, inflated dollars.