Tax deductions. We hear about them all the time and they are often advertised as a benefit of carrying a mortgage or student loan. But, do you actually come out ahead? As always, this post is not a “what to do” or “what not to do” post. Instead it is simply me sharing the results of a ton of reading, investigating and some basic math. For the sake of our discussion we will walk through an example using a student loan and one using a mortgage.
As of 2014 the US median household income was $51,939. Therefore, that will be our point of reference in our example. Okay, let’s say our family has $30,000 in student loan debt to go with their $51,939 income. Federal student loans allow you to deduct up to $2,500 per year in interest as a tax deduction. Very quickly let’s go over how a tax deduction works. A tax deduction allows you to deduct a specified amount from your taxable income. For example, if you have an income of $100,000 and you have a $10,000 tax deduction you will only pay taxes on $90,000. Got it? Good. Let’s return to our example. We will assume our family will get the maximum $2,500 deduction. If we subtract our $2,500 deduction we will only be taxed on $49,439. But, what is our actual savings? Well, a couple married filing jointly with an income of $51,939 will be in the 15% federal income tax bracket. Therefore, the tax deduction savings will be the difference in the taxes paid on $51,939 vs taxes paid on $49,439. Let’s to do math:
$51,939 x 15% = $7,790.85
$49,439 x 15% = $7,415.85
Tax Savings = 7,790.85 – 7,415.85 = $375
Using the calculations above you will see that our tax deduction saved us $375 in taxes. In this example, we sent the student loan company $2,500 in interest to avoid giving the government $375 in taxes. To make things worse, $2,500 is the maximum deduction. Therefore, even if you paid $10,000 in student loan interest you can only deduct $2,500. So the situation could be even more lopsided than our example! Hmmmm. Let’s try it again with bigger numbers and see if it changes the math.
In this example we will use a family that has a higher income and a mortgage. This time the family has a household income of $150,000 per year which places them in the top of the 25% federal income tax bracket. The family is in the first year of a $250,000 mortgage (The most interest is paid in the 1st year) at 4% interest. By the end of the year they will have paid ~$9,099.96 in interest if they had a 30 year mortgage. Using the tax deduction, their taxable income will become $140,900.04. Let’s see how much this tax deduction will save them.
$150,000 x 25% = $37,500
$140,900.04 x 25% = $35,225.01
Tax Savings = $37,500 – 35,225.01 = $2,274.99
In this example the math again does not work. This time, we sent the mortgage company $9,099.96 in interest to avoid giving the government $2,274.99 in taxes! I should also note that in the United States we have a marginal income tax system. This means only the amount of money that exceeds the higher tax bracket is taxed at the higher amount (We will discuss this more at a later time). The point I am making is that the equations I have used overestimate the amount of income tax one would actually pay in these scenarios and the math is still abysmal.
The take home message: Tax deductions are definitely something to utilize if they are available in your situation. However, they ARE NOT a good reason to keep a mortgage or student loan around instead of paying them off. Something to think about.