| When you work through the numbers, the savings that | | | | NOTE |
| stem from early repayment of a loan can seem | | | | The marginal tax rate is the tax rate you pay on your |
| almost too good to be true. Can a few dollars a month | | | | last dollars of income. |
| really add up to, for example, $25,000 of savings? | | | | For example, suppose you have four savings options: |
| When you save money over long periods of time and | | | | a credit card charging 12 percent nondeductible |
| let the interest compound, the amount of interest you | | | | interest, a mortgage charging 6 percent tax-deductible |
| ultimately earn becomes very large. In effect, when | | | | interest, a tax-exempt money market fund earning 4 |
| you pay an extra $20 a month on a 9 percent | | | | percent; and a mutual fund earning 9 percent taxable |
| mortgage, you're saving $20 each month in a savings | | | | interest income. To know which of these savings |
| account that pays 9 percent. By "saving" this $20 over | | | | opportunities is best, you need to calculate the |
| more than 25 years, you earn a lot of interest. In the | | | | after-income-taxes interest rates. If your marginal |
| earlier example, this monthly $20 really would add up | | | | income tax rate equals 33 percent--meaning you pay |
| to roughly $23,000. | | | | $.33 in income taxes on your last dollars of |
| But you can't look just at the interest savings. If you | | | | income--the after-income-taxes interest rates are as |
| placed the same $20 a month into a money market | | | | follows: |
| fund, purchased savings bonds, or invested in a stock | | | | 12 percent interest on the credit card |
| market mutual fund, you would also accumulate | | | | 6 percent interest on the mutual fund |
| interest or investment income. | | | | 4 percent interest on the mortgage |
| How can you know whether early repayment of a | | | | 4 percent interest on the tax-exempt money market |
| loan makes sense? Simply compare the interest rate | | | | fund |
| on the loan with the interest rate (or investment rate of | | | | In this case, your best savings opportunity is the credit |
| return) you would earn on alternative investments. If | | | | card; by repaying it you save 12 percent. Next best is |
| you can place money in a money market fund that | | | | the mutual fund because even after paying the income |
| earns 6 percent or repay a mortgage charging you 9 | | | | taxes, you'll earn 6 percent. Finally, the mortgage and |
| percent, you'll do better by repaying the mortgage. Its | | | | tax-exempt money market fund savings opportunities |
| interest rate exceeds the interest rate of the money | | | | produce 4 percent after you deduct the effect of |
| market account. But if you can stick money in a small | | | | income taxes. |
| company stock fund and earn 12 percent or repay a | | | | TIP |
| mortgage charging you 9 percent, you'll do better by | | | | The difference between percentages such as 12 |
| putting your money in the stock fund. | | | | percent and 6 percent may not seem all that large. But |
| One complicating factor, however, relates to income | | | | choosing the savings opportunity with the highest |
| taxes. Some interest expense, such as mortgage | | | | after-income-taxes rate delivers big benefits. If you |
| interest, is tax-deductible. What's more, some interest | | | | invest $20 each month in something paying 6 percent |
| income is tax-exempt, and some interest income isn't | | | | after income taxes, you'll accumulate $5,107 over 25 |
| tax-deferred. Income taxes make early repayment | | | | years. But if you invest $20 each month in something |
| decisions a little bit complicated, but here are four rules | | | | paying 12 percent after income taxes, you'll |
| of thumb: | | | | accumulate $13,848 over 25 years. |
| If you're a business owner with the ability to invest | | | | The second complicating factor stems from the tax |
| additional funds in the business--and that investment will | | | | deduction you sometimes get for certain kinds of |
| produce extra profits--you should usually make this | | | | investments, such as IRAs and 401(k) plans. When you |
| investment first. Investments in small businesses often | | | | get an immediate tax deduction, you actually get to |
| return 20 percent to 30 percent annually. If you can | | | | boost your savings amount by the tax deduction. This |
| get that sort of return, every other opportunity pales in | | | | effectively boosts the interest rate. |
| comparison. Note that in Chapter 14, I describe how to | | | | For example, if you have an extra $1,000 to save and |
| estimate the returns you receive from business | | | | use it to repay a credit card charging 12 percent, you |
| investments. | | | | will save $120 of interest expense (12% * $1,000). |
| Usually, if you have extra money that you can tie up | | | | If you save the $1,000 in a way that results in a tax |
| for a long time and can't invest additional money | | | | deduction, such as through an IRA, things can change |
| profitably in your business, you'll make the most money | | | | quite a bit. Say your marginal income tax rate is 33 |
| by saving your money in a way that provides you with | | | | percent. In this case, you can actually contribute $1,500. |
| an initial tax deduction and where the interest | | | | ($1,000 / the factor [1-marginal tax rate]). The arithmetic |
| compounds tax free, such as a 401(k) plan or an IRA. | | | | might not make sense, but the result should. If you |
| (Opportunities in which an employer kicks in an extra | | | | have $1,000 to save but you get a 33 percent tax |
| amount by matching a portion of your contribution are | | | | deduction, you can actually save $1,500, because you'll |
| usually too good to pass up--if you can afford them.) | | | | get a $500 tax deduction ($1,500 #33%). |
| If you've taken advantage of investment options that | | | | What's more, by investing in a tax-deferred |
| give you tax breaks and you want to save additional | | | | opportunity, you avoid paying income taxes while |
| money, your next best bet is usually to pay off any | | | | you're earning interest. (A tax-deferred investment just |
| loans or credit cards that charge interest you can't | | | | lets you postpone paying the income taxes.) If you |
| deduct, such as credit card debt. Start with the loan or | | | | invest in a stock mutual fund earning 10 percent, for |
| credit card charging the highest interest rate and then | | | | example, you can keep the whole 10 percent as long |
| work your way down to the loan or credit card | | | | as you leave the money in the stock mutual fund. If |
| charging the lowest interest rate. For this to really | | | | you work out the interest income calculations, you |
| work, of course, you can't go out and charge a credit | | | | would find that you earn 10 percent on $1,500, or $150. |
| card back up to its limit after you repay it. | | | | So the tax deduction and the tax-deferred interest |
| If you repay loans with nondeductible interest and you | | | | income mean you'll earn more annually on the stock |
| still have additional money you want to save, you can | | | | mutual fund paying 10 percent than you will save on |
| begin repaying loans that charge tax-deductible | | | | the credit card charging 12 percent. |
| interest. Again, you should start with the loan charging | | | | Be aware that ultimately you pay income taxes on the |
| the highest interest rate first. | | | | money you take out of a tax-deferred investment |
| Understanding the Mechanics | | | | opportunity, such as an IRA. In the example, you would |
| Successful saving relies on a simple financial truth: You | | | | need to pay back the $500 income tax deduction, and |
| should save money in a way that results in the highest | | | | you would also need to pay income taxes on the $150. |
| annual interest, including all the income tax effects. | | | | (At 33 percent, you would pay $50 of taxes on the |
| It's tricky to include income taxes in the calculations, | | | | $150 of interest income, too.) |
| however. They affect your savings in two ways. One | | | | In general, however, if you're saving for retirement, it |
| way is that they may reduce the interest income you | | | | usually still makes sense to go with a savings |
| receive or the interest expense you save. If interest | | | | opportunity that produces a tax deduction and lets you |
| income is taxed, for example, you need to multiply the | | | | postpone your income taxes. The reason is that the |
| pretax interest rate by the factor (1-marginal tax rate) | | | | income taxes you postpone also boost your |
| to calculate the after-income-taxes interest rate. And if | | | | savings--and thereby boost your interest rate. (It's also |
| interest expense is tax-deductible, you need to multiply | | | | possible that your marginal income tax rate will be |
| the interest rate by the factor (1-marginal tax rate) to | | | | lower when you withdraw money from a tax-deferred |
| calculate the after-income-taxes interest rate. | | | | savings opportunity. |