4 Ways People Try to Avoid Uncle Sam at Tax Time

Gimme an I! Gimme an R! Gimme an S! Whatcha got? Taxes!

Not exactly a cheer that will get people fired up, is it? Most people want to avoid paying taxes as much as possible, and they may go so far as to invest money in something just to avoid Uncle Sam. Here are some ways they do it, and why none are a good idea just for income tax savings.

Opening a Traditional IRA

Some people looking for a way to put themselves in a lower tax bracket will open a traditional IRA and write off whatever money they put in there. While it’s good to save money, there is a problem with this strategy. The first place you should put money for retirement is into a matching 401(k) plan, and then a Roth IRA, which grows tax free. Any money that goes into a traditional IRA is tax-deferred, which means you pay taxes on it when you take it out (when you’ll most likely be in a higher tax bracket). You are saving money now only to pay it later, so it’s not the best deal. Learn more about the best way to invest.

Annuities

Keeping with the investing theme, an annuity is simply a savings account with an insurance company. It can be tax-sheltered, but the problem is that you usually pay an extra fee to get that shelter. You save on taxes but pay money out to save, and that doesn’t help you. The only time it might be good to use a variable annuity is when you’ve maxed out all other retirement savings and your house is paid for, and most people aren’t there yet. Don’t open one just to save on April 15. Learn more.

Whole Life/Cash Value Life Insurance Policies

A salesman might pitch to you that the interest accumulated on the savings portion of a whole life or cash value policy does so free of taxes, so it’s good to save your money there. However, that “good” isn’t just bad—it’s ugly. The rate of return on whole life is about 2.6%. If you invested money at 12% in a mutual fund and had to pay taxes on the gains, you would still net about 9.6%. Why earn 2.6% on one tax-free investment when you can net 9.6% on another? Read more.

Keeping the Mortgage

This one is a little more long term, but it’s important to address. Don’t keep a mortgage for the tax deduction. Your deduction isn’t dollar-for-dollar, which means you’ll pay more in interest than you save with Uncle Sam.

As an example, if you have a $200,000 balance at an interest rate of 5%, that’s $10,000 a year that you pay to the bank. If your income puts you into a 25% tax bracket, then not having a mortgage (or interest to go with it) means you pay $2,500 to the government on that extra $10,000 in the form of taxes. Do you really think it’s smart to pay the bank $10,000 so you don’t have to pay the government $2,500? We didn’t think so. Pay the mortgage off and be done with it.

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