Business

Should charity or bank get your money?

John Perry is an assistant professor of economics at Centre College in Danville.
John Perry is an assistant professor of economics at Centre College in Danville.

Question: My tax adviser suggests that I go into debt (i.e. buy more property, invest in businesses) to get deductions to lower my annual income tax liability. Does that make sense?

Answer: Taking on debt to generate a tax deduction does not make sense. The idea goes something like this: you borrow money and the interest you pay can sometimes be deducted from your income for tax calculation purposes. For example, if you pay $5,000 in interest, you might be able to escape paying taxes on that $5,000. It might sound brilliant but think about what you have done. You gave a bank $5,000 so you would not have to pay taxes on the $5,000. You would have gotten the same tax deduction if you had instead given $5,000 to a charity.

In either case, you are giving away $5,000 to get a $5,000 tax deduction. However, a tax deduction is not how much your tax bill will fall. If your marginal tax rate is 40 percent, the deduction lowers your tax bill by only $2,000. To get a $2,000 reduction in taxes you spent $5,000. Ouch.

And this does not consider that adding debt to your life increases financial risk in almost every instance. We all know how fast an investment's value can go down, but any debt associated with the investment has a nasty habit of sticking around regardless of what the investment is worth.

Q: When does it make sense to buy a big-ticket item with store financing (six months same as cash, for example)?

A: There is little benefit to using same-as-cash offers. If you pay for the item with cash instead of using an in-store financing offer, you give up the return on the money you would have gotten. But with such low interest rates on savings accounts, this would probably amount to just a few dollars on a $1,000 purchase, which is nothing to get excited about. However, if you miss paying off the loan balance by a specific date, many of these offers will charge you interest from the beginning of the loan. With interest rates of 20 percent or more, missing the payoff can be costly.

Also, unless you have a previous credit account with the store, you will be applying for a new line of credit. This could have a negative impact on your credit score.

In-store-financing promotions are a marketing ploy. I would suggest saving and then buying the item with cash and avoid borrowing at all.

Q: Should I start to draw Social Security when I'm 62 or wait until I'm older when it pays more per month? Or course, it would be easy to figure out if I knew when I was going to die, but I don't.

A: Taking early Social Security is really just a trade. You are trading away a higher future benefit at full retirement age for a significantly lower benefit at age 62. Since you only get Social Security payments while alive, whether this is a good trade comes down in large part to how long you will live, a secret the Grim Reaper keeps.

While you don't know how long you will live, you do know something about how long you might live. How healthy are you now relative to the average person your age? How are your siblings doing? How long did your parents live? How long did their parents live? The Social Security Administration knows the importance of life expectancy on the choice and has resources on their Web site to help. One is a life expectancy calculator available at Ssa.gov/planners/lifeexpectancy.htm.

A simplified rule is that if you expect to live longer than the average, it makes sense to hold off and take Social Security at your full retirement age. If you expect otherwise, taking early retirement might be better.

There are other considerations. If your spouse is eligible for a spousal benefit and you take early retirement, his or her benefit will be reduced as well. Taking early Social Security also places limitations on how much you can work and earn before your Social Security benefits are reduced. That can also factor into where you will get health insurance, as Medicare starts at age 65.

In the end, the best decision is dependent on individual circumstances. However, something that might take some of the pressure off is realizing that the decision is reversible. Because of a little known rule, a person who took Social Security early can decide to stop payments, repay Social Security, and then restart benefits typically at a much higher amount.

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