Why Tax Deductions Aren't Always a Good Thing

By Neal Frankle

During tax season the words, "It's deductible," are often music to our ears. But just because something is tax deductible doesn't mean it's in your best financial interest. A tax deduction is not a rubber stamp of approval on how to spend your money or what debt to incur.

One of my self-employed clients, Tom, recently called me for some advice. Tom had just received $10,000 in windfall profits. He needed to know if he should pay off his credit cards or his car loan with the money. The car loan was costing him 9.7 percent interest. But the car was owned by his small business and, therefore, the payments were deductible. The credit card was charging 2.9 percent interest on his debt, but would go up to 15 percent in January 2012.

I did some quick calculations and figured that the car loan, after the tax deduction, was still costing Tom about 6 percent. Tom is in the 40 percent tax bracket. So, if the total interest on the car loan was $1000, he writes $1000 off of his taxable income, and that saves him $400 in taxes. As a result, the car loan is still costing Tom $600, even after the $400 in tax savings.

I asked Tom if he could pay off the credit card by January if he paid off the car loan now. He said he could. I therefore suggested that he pay off the car loan immediately and then work to pay off the credit card balance before the rate skyrocketed to 15 percent next January. We did the math together and I explained how the car loan was still costing him more than the credit card was-even after the tax benefit.

It's very nice to get a tax deduction. But you need to stay focused on the after-tax cost rather than simply looking at the tax savings. Let's say you have a home mortgage that costs you 4 percent. If you are in the 40 percent tax bracket, your after-tax cost is actually 2.6 percent. This is a very low cost to borrow money and it's a nice tax deduction. But if you earn less than 2.6 percent on your money after-tax, you are better off if you pay that mortgage off. Having the least-cost debt that you can afford or having no debt at all if you can is also the best way to have a good credit score.

Neal Frankle is a certified financial planner and runs Wealth Pilgrim, a personal finance blog that helps people make smart decisions about their money. As a start, he suggests that you strive to understand your credit score range.