- For important money decisions, always consider the potential for tax deductions, tax-deferment, and a mortgage interest tax deduction.
- Each of the tax levers above can make a big difference when you start compounding your savings over time.
- While adding a few hundred dollars extra to your monthly mortgage payment can shorten your loan term and save you thousands of interest in the long run, you should compare that to other tax advantaged options.
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Let’s say you’re 50 years-old and you have an extra $900 a month to work with. Should you use that money to pay down your mortgage or contribute it to your 401(k)? Assume you just refinanced your mortgage for $450,000 over 15 years at 3.5 percent interest— so you’re paying $3,217 a month. Also, assume you have $500,000 in your 401(k) account and you’re putting away $10,000 annually, which is growing at 7 percent.
Choice 1: Pay off the mortgage early. You apply the extra $900 a month to your mortgage and guess what? Your mortgage is paid off after only 11 years instead of 15.
Let’s see what happens to the 401(k) in the meantime by pulling some important “financial levers.”
With Lever 1, you’re putting away $10,000 a year on a tax-deductible basis. With Lever 2, the money is growing, compounded monthly, at 7 percent per year. By using those levers, you’ll have $1,688,000 in your 401(k) by the time you reach age 65. But, you also have four more years left of an extra $4,117 to invest ($3,217 + $900). That comes out to $218,000, when it’s compounded at a 5 percent rate of return. Why 5 percent? That’s what you earn after taxes on 7 percent (if you’re in the 28 percent tax bracket). So when you add $218,000 to the $1,688,000, the total of those two sums is $1,906,000—That’s Choice 1.
Choice 2: Add the extra $900 (tax-deductible) into your 401(k). If you’re in the 28 percent tax bracket, that $900 tax-deductible is the equivalent of $1,250 pre-tax. If we take the $1,250 times 12 months, that’s $15,000 per year—or the equivalent of $25,000 away pre-tax (Note – current maximum contribution to a 401(k) in 2016 is $24,000).
Under this scenario, Lever 1 is $25,000 a year, tax-deductible. Lever 2 is tax-deferred at 7 percent compounded monthly. Lever 3 is a mortgage interest deduction during the entire period. That results in a total of $2,085,000 in the 401(k) by the time you are age 65. If I take the two results, you can see that Choice 2 results in roughly $179,000 more than Choice 1–$2,085,000 versus $1,906,000.
Hence the power of three important levers: (a) tax-deduction, (b) tax-deferment, and (c) mortgage interest tax deduction all of which make a big difference when compounded over time.
Until next time, enjoy.
Gary Klaben is in our Glenview, IL office and serves our clients who are now located all over the country. He has over 30 years of experience and is the author of Changing the Conversation, The Wealth Sanctuary and co-author of The Business Battlefield. Whether advising his clients, mentoring his team, or coaching entrepreneurs, he is always simplifying complexity and motivating others to take the next action that’s right for them.
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