A tax deduction is not always a good thing.
Let me repeat this: Just because something is deductible, that does not mean you should spend the money.
Why in the world would I say this?
Because I think that many people have lost sight of what exactly a deduction is. First of all, a tax deduction is simply a REDUCTION of your income in the eyes of the IRS. So, if you are in the 30% tax bracket, and you can deduct $1,000, you will only receive $300 back. With a deduction, you only receive the amount by which you reduced your total tax burden back, not the (your) cost of the whole deduction.
We forget this, and go out and make a decision simply because it is tax-deductible. For example, you roll your capital gains deferral from your primary residence into a newer, bigger house because the interest is deductible. Your old house had a $180,000 mortgage at 5% for a payment of $966. The total yearly deductible interest from that note is about $9000. Now, this does not mean you get a check from the IRS for $9000 at the end of the year. Rather, you reduce your income by $9000, which if you are in the 30% tax bracket comes out to a $3000 check back from the IRS. Not nearly as cool.
Now, your new house has a mortgage of $240,000 over 30 years at 5%, and a payment of $1395. You can deduct $12,000 for the year from your income, but the check from the IRS will only be $3,600.
Wait a minute. You only get $600 more back from the IRS, and your cost of owning a home is $5,148 more per year. So, your decision has cost you a $4,548 reduction in your cashflow a year.
Not such a great deal, now is it?
In our society today, the word risk has a horrible connotation. Why? People associate risk with irresponsible behavior and high failure rates. In the financial world the term risk simply means uncertainty. If we can predict an event with accuracy on a regular basis, the event is considered low risk. Conversely, if we cannot, it is considered high risk.
Right now in my life I crave a certain amount of security. I would prefer to have a large amount of security. However, security can be just as damaging to your overall financial health as risk can.
If you save too much of your money without growing it, and you have a fear of the “risk” associated with higher yielding accounts or even the market, you may see a decrease in your buying power due to inflation.
True story, I swear, but when I worked with the bank I remember I had a client who distrusted banks and anything financial. Well, instead of putting her money into investments and higher yielding accounts, she put it in a drawer of a table. No joke, one day her house was hit by a tornado. Her money flew throughout the neighborhood, raining down on her joyous neighbors. Well, she thought she was doing something safe and secure, but she wound up losing a good amount of savings in the process.
I feel that If you never take any risk, you will never move forward. These “risks” you take could come in almost any form – asking for a raise, moving to a better neighborhood, starting a new company, investing in the market, selling your home. Because you do not know the outcome of any of these events, they all have inherent risk.
If you never ask for a raise, will your employer likely give you the value that you create?
No.
Why not? Your employer is most likely a smart businessperson. They will pay you the least amount possible to keep you happy and productive.
Nevertheless, if you walk into any of these major decisions lightly, and without thought of the possible various outcomes, the events can be disastrous. For example, take the person who decides to begin flipping homes – with no previous experience, and without considering current market conditions. I think the increase in foreclosures paints the picture of those who went into a speculative market uninformed.
What is the solution? Balance.
In order to move forward, to truly succeed, you have to take risks. Otherwise you wind up burying all of your savings in the yard and perhaps losing its location at worse, and at best, seeing a vast decrease in your buying power. However, you do need some security, some soft landing for the hard times. I really believe a good reserve fund will give you that security, as well as the capital and flexibility to take other financial risks without devastating yourself if the results are not as favorable as you hoped.
