In general, tax deduction should be the secondary reason not the primary reason for your spending.
In other words, do not overspend for the sole purpose of claiming the expense as a deduction in order to get more refund during tax time!!
Spending just to claim a tax deduction is like spending $1 to get 30 cents back, assuming that your federal and state tax rate is 30%. If I tell you to give me a $1,000 so I can give you back $300, would you even consider doing it??
The government is trying to be nice by helping you out with the cost by providing these kinds of incentives but do not overdo spending to maximize your tax deductions. Below are some of the shortsighted mistakes people can easily make when it comes to maximizing tax deductions:
1. Iâ€™ll have more kids so I get more tax deduction and credits.
Let’s see, if you have dependents you are allowed one exemption for each qualified dependent plus any appropriate credits where you would qualify. Assuming that the dependent exemption for a child is $3,300 and your marginal tax rate is 20%. The tax benefit of claiming a dependent child is your marginal rate times the exemption so in this case you can reduce your tax liability by $660 ($3,300 x 20%) and if we include the child tax credit, the total tax relief for one child would be just $1,660. Do you know how much raising a kid cost? Iâ€™m pretty sure itâ€™s more than $1,660 a year. If you have an infant, youâ€™ll probably spend $300 per month on diapers and $200 per month on milk. Thatâ€™s $6,000 per year already not counting any other miscellaneous expenses. So, if you want to have additional kids, do it because you wanted to, not because you can get extra tax deduction for it.
2. Iâ€™ll donate more money to charity
Charitable donations such as cash or properties to qualified organizations are tax deductible. If you want to donate money out of your good heart, Iâ€™m not going to argue with that. The tax deduction is just a bonus for being generous. But to do it for the sole purpose of maximizing your deduction to get more refund is just plain ridiculous.
3. Iâ€™ll get a much expensive house to get more tax deduction
Iâ€™ve seen people actually do this where they chose a much more expensive house so that it would give them a higher mortgage resulting in higher interest payments. It may be ok if you can really afford it but if you are on the borderline of the affordability index, you may think twice about purchasing the bigger house.
4. Iâ€™ll overspend on my home-based business
Ok, the advantage of being in a home-based business (or business in general) is that there are a lot of tax deductions that are available to the home-based business owner than to the employees. Some expenses that employees cannot deduct (or can deduct but with a stricter requirements and limitations) but businessâ€™ owners can are meals and entertainment expenses, travel expenses, home-office expenses, vehicle expenses, laptop computers, office supplies, etc. But you do not want to overspend just because you can deduct those expenses; youâ€™ll go out of business really fast. Doing so is like running a business where you buy a product for $1 and sell it for just 30 cents.
5. Iâ€™ll spend money for work even if I donâ€™t get reimburse
Unreimbursed employee expenses are tax deductible subject to certain rules and limitations. Your main goal when you incurred these expenses is to get reimburse by your employer first then report the ones that are not as your tax deductions. But do not go on a spending spree for your employer just because you can deduct the unreimbursed ones. Please keep in mind that the unreimbursed employee expenses are only deductible if you are itemizing and are subject to the 2% of your AGI limitations. Also, please keep in mind that employer reimbursements are dollar for dollar return of your money while tax deductions are just a percentage return of your expenses.
6. I have gamble winnings so Iâ€™ll gamble to lose
Iâ€™m not sure if this really counts as a mistake because if you are addicted to gambling, you would still gamble even if you donâ€™t have any winnings and probably lose money anyways. But Iâ€™ll throw it in here anyways!! Assuming youâ€™ve won in the final month of the tax year, in most cases itâ€™s December, but you have not lost during the first 11 months so you gamble to lose so that you can offset those losses against your winnings. Gambling losses are only deductible up to amount of your winnings.
7. I will not adjust my W-4 withholding to get huge refunds during tax time
This is not really a deduction but most people still commit this most common mistake. Most people love to see a huge refund come tax time and do not adjust their W4 withholding. This is actually not good since you are loaning your money to the IRS at 0% interest. If you can get your tax dollars on a monthly basis and have $0 refund when you file, you may be able to invest that and earn decent interest.
One of the best articles in a long time! Each point is well thought out Ken! I especially liked the one on Charity and expensive house! When we were house hunting we kept hearing the same story over and over again – don’t worry about the cost, you get a tax deduction! Looking at their enthusiasm, for a minute I wondered if it was a deduction or a tax credit!! 🙂
Thanks money cone, and most of this stuff, I heard from people on how they increase tax deduction.
You can deduct sales tax now right? I’m sure some people rationalize buying more stuff so they can get more sales tax write off.
I disagree with your charity giving though. If someone want to give to charity, that’s a good thing. 🙂
Like I said in the article, I won’t argue with people who wants to donate out of their good heart. I donate to charity a lot even if I am not able to deduct them since I do not itemize on my return. I do it to help and not to reduce my taxes.
I don’t argue the donation move but I would on the purpose of the donation. If a taxpayer is finding ways of saving money by saving on tax dollars, and if saving on tax dollars means adding more deductions, then it does not make sense at all. It defeats the purpose on saving money since when it comes to getting refunds, you are only getting cents back for every dollar you spend.
And yes, it is always good for the organizations but it may be detrimental for the donor if he/she is overdoing the donations more than he/she is supposed to as this affects his/her own financial well-being.
It always strikes me when friends go around bragging how much of a tax refund they got – I think they’ve forgotten it’s their own money they’ve given away all year and are finally getting returned!
Thanks Dana. A lot of people that I know are very happy that they have a huge refund in the end and they brag about it. If their refund was reduced by a lot from a previous year, they went from one accountant to another but only to get the same result. They complain about not having a huge refund.
Tax refunds are just 0% interest loan to the government.
Buck Inspire says
Terrific article. People should be more educated about a huge tax refund is actually bad because you are giving the government an interest free loan. Similar to gambling, making bad stock moves and justifying it with tax deductions. Better way is to tighten your trading strategy!
I agree with you on the stocks. Some people do justify their losses with the tax deductions.
ann @ merchant services says
Everyone should read this so that they will be aware about huge tax refund. They must understand the consequences if they will continue this. Thanks for posting!
thanks for your comments.
Yeah, the IRS the bad asses! Thank you so much for sharing, I really liked how you embodied the step by step procedure mistakes. Kudos!
Paula @ AffordAnything.org says
It’s amazing how many people buy a bigger home, with a bigger mortgage, for the so-called tax “benefit”, especially before the housing bubble crashed. Spending money for a tax deduction, like you say, makes as much sense as spending $1 to get 30 cents.