When making investment decisions, people often ask: "If I do this, will it reduce my taxes?" A better question is usually: "If I do this, will I have more left in my pocket when I'm done?"
Although these queries may seem to be two ways of asking the same question, the answers are quite often different. How much we save on taxes depends on how much we pay to the taxing authorities. How much we have left in our pocket depends not only on how much we pay to the taxing authorities but also on how much we pay to third parties in transactions having income tax attributes. If we pay out $100 to save $50 in tax, we haven't accomplished much.
Suppose you want to buy a new car and are trying to decide whether to pay cash or to finance it. (Obviously, with today's car prices, that choice is not always available but assume for the moment that it is.)
If you think primarily about saving taxes, you would probably borrow the money because the interest you pay would be a tax deduction. However, with a 50% maximum tax rate (for now, at least), the most you can hope to save in taxes is about half of the interest paid. The other half is out of pocket and gone. In lower tax brackets, the saving is even smaller. Generally speaking, if you don't have to borrow you probably shouldn't--and tax savings usually won't change that conclusion.
Suppose your car dealer suggests that you lease your new business car. Sometimes car-leasing representatives make it sound as though leasing produces bigger tax deductions than buying, ". . . because the entire payment is deductible."
But, for a business auto, buying and leasing usually produce about the same tax deductions over the life of the vehicle, although the pattern of deductions from year to year may vary somewhat. A lease produces rental payments that are deductible when paid. A purchase produces interest and depreciation deductions.
Bear in mind, though, that a lease is really just an alternative form of financing--another way of borrowing money. The cost of borrowing under a lease is usually a little higher than in a purchase for a couple of reasons:
- Because no down payment is made, the amount borrowed is usually larger.
- The leasing company usually has to charge a slightly higher interest rate to pay for its cost of money and leave room for its own profit.
With costs a little higher and deductions about the same, you may have a little less in your pocket in the end under a leasing arrangement. Of course, there are other advantages to leasing: The leasing company may do your car shopping for you; you tie up less money during the early portions of a lease (no down payment); and the leasing company may provide a loan car while yours is in the shop.
If you are thinking of leasing a personal (non-business) car, bear in mind that none of your lease payment will be deductible, even though part of each payment is similar to interest. For tax purposes, a lease is strictly a rental arrangement. No interest deduction is available.
Suppose you are thinking about a tax-shelter investment. It might be wise to ask yourself something like this: "After I give this salesman my money (which I may never see again) and claim my new tax deductions (which I may lose if I'm audited), will I have more left in my pocket when I'm done?"
Don't let the promise of big tax savings lure you into making an expensive investment of questionable worth.
Bear in mind, too, that the tax information supplied by investment promoters is usually based on general conditions for the average high-bracket taxpayer and may not apply in quite the same way to your specific situation.
If an investment makes good business sense in and of itself, then any tax savings are gravy and nice to have. Conversely, if an investment offers no real return other than promised tax savings, it may be a bum deal that should be avoided.
Some of these investments are like a showgirl's costumes--flashy, but not much to them.