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blog (coffee shop)
by In order to determine the best place for my money, I've developed the habit of using a simple interest rate comparison. For example, if I had a home loan with a 4.5% interest rate, a savings account with a 5.27% rate, and a credit card at 18.0%, I would apply my uncommitted funds towards the credit card. (Although it wouldn't actually pay me interest, it would effectively "increase" by preventing me having to pay interest.) If I didn't have a credit card balance, however, I'd put the money in the savings account rather than pay extra on my home loan (because 5.27% > 4.5%).
Seems straightforward enough, right?
Wrong. Recently I learned such a comparison is inherently flawed - at least when making a determination between a savings account and a debt. The reason? Taxes. If I had just the 4.5% home loan and the 5.27% savings account, it may make more economic sense to pay extra on the house, seeing that part of the interest earned on the savings money will go to taxes. For example, in the U.S., the current maximum tax rate on interest (capped at 15% instead of 35%, thanks to Bush's tax cuts) would drop my net earnings on the savings account from 5.27% to 4.48% - a lower rate of return than the home loan.
Of course, if a certain politician is elected and keeps his campaign promises, such interest may no longer be taxed - in which case we can all breath a sigh of relief and go back to our straightforward interest rate comparisons.
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The situation is actually a bit more complicated than you indicate. The tax on the interest bearing savings accounts is not capped at 15%, but is included in your regular income via line 8a on form 1040 (instructions, p. 23). So, your interest rate is determined by your effective tax rate. For lower incomes, this may mean that the effective interest rate on your savings account is still higher than your on your mortgage. For example, due to the education tax credits for the Katrina and Rita effected areas, my effective federal tax rate has been 0% for the past two years, meaning that the savings account would have been the better option for me.
I'm not sure I follow you. If the tax rate on taxable interest is capped at 15%, then of course it can be lower (as in your case), but how do we know it can be higher? Can you assume simply because it is included as a line item that it is treated the same as salary/wages? I guess that would make sense (given the layout of form 1040), but how, then, do the Bush tax cuts take effect?
Perhaps I found my own answer. Per the form 1040, line 8a instructions to which you linked:
Enter your total taxable interest income on line 8a. But you must fill in and attach Schedule B if the total is over $1,500 or any of the other conditions listed at the beginning of the Schedule B instructions (See page B-1) apply to you.
Perhaps it is only when a Schedule B (second page) is required that you have the potential to take advantage of Bush's tax cuts...
In any case, for informational purposes: According to this article on bankrate.com, the conditions for filling out Schedule B include:
- You sold your home or other property, provided seller financing and the buyer used it as a personal residence.
- You received interest or dividends as a nominee, that is, the earnings are in your name but they actually belong to someone else.
- You received a Form 1099 for interest as a purchaser of a bond with accrued interest.
- You received a Form 1099-INT for tax-exempt interest.
- You had a foreign account or received a distribution from a foreign account.
As you said, a Schedule B (instructions) is filled out if your interest exceeds $1,500. However, it is merely an itemized list of all your interest (B - line(s) 1) and dividend (B - line(s) 5) sources, and you total interest (B - line 2) less your excludable interest (B - line 3) is entered in line 8a on the 1040. Line 8a is included in your total income (1040 - line 22), so it is taxed as normal income. In other words, it is not capped at 15%. The 15% cap applies to capital gains from the sale of a capital asset (most property is included, see the Schedule D instructions), and for those you need to fill out a Schedule D (instructions).
That makes sense.
For reference, here are the income tax rates for 2007, which are different from the capital gains tax rates.
Dont forget the interest we all owe on the Government's deficit. Bush needs to collect more tax money. He never could afford those tax cuts - that was only about getting elected.
Bush needs to collect more tax money.
I actually think he needs to spend less.
One additional thing that you have to factor is that your interest on your home loan is tax deductible. So, if you are at a at 35%, for example, the interest that you pay on your 4.5% home loan would turn into an effective rate of just 2.93%, so you would still be better off in the savings account. If you changed your example to a auto loan with a 4.5% rate then your analysis holds since interest paid on auto loans is not tax deductible.
When you say "tax deductible," do you mean the interest paid on your mortgage is deducted from your taxable income? Or is that exact amount directly refunded? If the former is true (and I'm pretty sure it is), I don't think your analysis is correct.
Continuing the example in my post (a 4.5% home mortgage vs a 5.27% savings account), let's say I put $100/month extra towards my home loan. If my loan amount is $150,000, I would pay about $6,700 in interest the first year paying the minimum payment. If I pay $100 extra, this amount drops to $6,675 - in line with earning 4.5% yearly interest on a $100 monthly annuity (F=A*[([1+i]^n)-1]/i). Assuming my income is $60k, the deduction would bring my taxable income down either to $53,300 or $53,325 - a change my gut tells me would be worth the same on my tax return in either case.
Paying $1,000/month extra would drop the interest paid to $6,450; $2,500/month -> $6,075; $5,000 -> $5,450. None of these differences seem big enough, in my opinion, from the interest paid making the minimum payment to have an impact on the tax refund amount. I mean, does the IRS really differentiate between taxable incomes as close together as $53,300 and $54,550?
Putting these values into the savings account, however, would result in earning $295, $735 and $1,470, respectively - as compared to $250, $625 and $1,250 saved in the 4.5% home loan. My feeling is the tax refund would be hard pressed to make up the $45, $110 or $220 difference.
I mean, does the IRS really differentiate between taxable incomes as close together as $53,300 and $54,550?
Yeah, they do. They differentiate down to $50 once you exceed $3,000 in income (less for lower income). The tax tables start on p. 67 of the 1040 instructions. In line with your example, a change from $53,300 to $52,325 in taxable income (line 43) would net you no change in taxes. However, the change of $53,300 to $53,550 in taxable income from the $1000/month extra payments, would give you a net increase in your taxes of $37 (married filing jointly, $62 otherwise). (Of course, these numbers change once you've included your deductions, etc.) So, paying down your mortgage faster has a negative impact on your tax bill.
I must say, though, that I agree with your original premise that interest rate comparisons are not a straight forward measure of where to put you money. For large differences, 18% v. 5%, its a no brainer; for smaller differences, it isn't clear cut.
(Standard disclaimer: I am not an accountant. Any advice I may seem to be giving is based upon my interpretation of the instructions found on the IRS website, and should not be deemed reliable tax advice. If you need tax advice, see an accountant.)
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Hey - let's not forget the "other guy" by scottb :: NR7 :: on 31 July 2007
Mitt Romney isn't the only candidate with campaign promises to reform stupid tax loopholes. Don't forget Ron Paul, who goes quite a bit farther along that direction.
Not that I'm particularly endorsing Ron Paul. It's just that, of all the candidates, he's the only one saying something new.
RE: Hey - let's not forget the "other guy" by Brandon :: NR9 :: on 31 July 2007
As I watched some of the Presidential debates, I couldn't help but identify with much of what Ron Paul said - and also feeling slightly bad for him when Giuliani pulled his emotional "9/11 was not our fault" stunt (which the press subsequently jumped all over). The issue, of course, is he is too extreme to be elected - and perhaps with good reason. He has some good ideas, but would he be able to turn those ideas into a series of bite-sized (i.e., moderate) improvements?
RE: Hey - let's not forget the "other guy" by scottb :: NR7 :: on 31 July 2007
Oh, I agree - Ron Paul is too extreme to get elected. Especially since the Republican party has in so many ways been hijacked by the religious zealots. But Romney's not really doing much better. Fred Thompson, who's not even officially running, is doing better.
Actually, for those who are interested, the Iowa Electronic Markets are a real-money futures trading system that offer trading on the outcome of the election. Because you can't put more than $500 in it, the commodities commission has declared it exempt from certain regulations, and it's not really any way to make serious money, but because it is real money, the underlying mechanisms of futures market are at work on it. This means that it's almost always a really good indicator of the likely outcomes.
It's been running since at least the '92 election, and it's been very accurate in predicting winners. Since trading on the 2008 Republican Party nomination opened in March, Romney's been pretty steady at around 22%. Giuliani started at around 35%, but then dropped down to around 20% in early June, and is now back in the lead at about 36%. Thompson's only been split out from the "other" group for about six weeks, but he's doing well at about 30%.
The bad new for the Republicans is that the "winner take all" market for the outcome of the 2008 election is running at about 65% in favor of the Democrats. In the Democratic nomination market, it's about 50% for Clinton and about 33% for Obama. The others are all pretty much in the toilet.
RE: Hey - let's not forget the "other guy" by Brandon :: NR9 :: on 01 August 2007
Romney's not doing much better than Ron Paul? Given the output of the Iowa Electronic Markets you cited, it looks to me as if his price (0.234) is about triple the category of "other candidates" in which Paul would be included (0.079).
(Here is the output for the Democrats, too.)
RE: Hey - let's not forget the "other guy" by scottb :: NR7 :: on 01 August 2007
Depends on what you're looking for. Yes, it's true that Romney's coupons are selling for much higher than Paul's. But it's a winner-take-all scenario, and there are two candidates selling at much higher than Romney, so I'd say Romney still has no more real chance of winning than Paul does.
BTW - I pointed to IEM because it's been around for a long time (so we have some history on which to judge its accuracy) and it focuses on political markets. But it's not the only one out there. InTrade is a regulated futures market, where big money can be spent, that includes some similar coupons.
They have more detailed markets, too. They show Romney winning the Iowa caucus and New Hampshire primary, but then getting pretty much slaughtered by Fred Thompson in the rest of them. They still show Giuliani as the front-runner for the Republican nomination, and they show the Dems way ahead in the overall race. They're specifically showing Clinton to beat Giuliani.
Futures markets are very cool things. Once they're in place, you can ask them a huge range of questions and get pretty good results. Studies show that (contrary to what economists predict) even play-money markets do a pretty good job at predicting things. There's a play-money market, Foresight Exchange, formerly Idea Futures, that's been running a long time. I first came across it in the early '90s. They allow any member to create new questions, so the range of questions is pretty huge. They've got questions on whether mathematicians will solve Goldbach's conjecture, whether the Catholic church will allow priests to marry, whether humans will achieve immortality, and the extent of US military deaths in Iraq.