Savings from paying mortgage early trumps tax deductions

"Pete The Planner" for IndyStar writes:  QUESTION

Dear Pete,

My husband and I have been making almost triple payments on our mortgage, in order to pay off our mortgage as quickly as we can. I mentioned this in the break room at work, and several people said it was a bad idea. They said that we would lose our mortgage interest deduction, and this would impact our taxes. I know that we get to deduct our mortgage interest from our taxes each year. So, should we slow down our mortgage repayment in order pay less in taxes?

— Sarah

Sarah: I have to admit, I hear this question/idea quite frequently.

It’s not uncommon for people to do everything in their power to legally avoid the outreached hand of Uncle Sam. Tax deductions were created for a reason, right? Absolutely, but you shouldn’t trip over yourself to get them. If your strategy is to pay mortgage interest in order to keep the tax deduction, you will lose every single time. It’s math. Never argue with math.

For example, if your gross household income is $80,000 and you pay $5,000 in mortgage interest, then your taxable income will become $75,000, after you’ve claimed the mortgage interest deduction on your tax return. Now, let’s say you have a marginal tax rate of 25 percent. Your mortgage interest deduction just saved you $1,250 in taxes. I gotta admit, that's pretty awesome. You paid $5,000 in interest and reduced your taxes by $1,250, for a net outflow of $3,750. Let’s now consider the alternative.

If you don’t have any mortgage interest to deduct, your taxable income will remain $80,000. You don’t get to legally avoid $1,250 in taxes, but you also don’t have to pay $5,000 in mortgage interest. Whereas having mortgage interest to deduct (in our previous example) results in a net cash outflow of $3,750, having no mortgage interest to deduct results in a net cash outflow of $0. The choice is simple. If you keep a mortgage, so that you can deduct the interest, you will pay a net amount of $3,750. If you don’t have a mortgage, you will pay nothing.

I don’t know why this financial myth exists, but it is prevalent. Do you want to know a better (legal) tax-avoidance strategy? Put $5,000 into a tax-deductible Individual Retirement Account. Per our example, you will reduce your taxable income to $75,000, reduce taxes by $1,250, and set $5,000 aside for the future. Using an IRA contribution to reduce taxable income makes much more sense than paying a bank interest to reduce your taxable income. The same strategy would work within a 401(k) or 403(b).

Despite what retailers and incorrect conventional wisdom may say, you can’t actually save money by spending money, or in this case, paying mortgage interest. However, you certainly can save money by saving money. And that’s why you should hustle to pay off your mortgage and seek out every tax deduction that’s based on saving, not spending.

You can read "Pete The Planner" at his site Here.