If you're wondering what to do to make your discretionary income work for you, paying off the mortgage on the nest and building wealth by investing pretax dollars are two options. For some people, the independence of being debt-free is more important than watching investments grow. Each strategy has tax implications that deserve close analysis.
Paying as Scheduled
Paying your mortgage as scheduled instead of paying it off early may help you reduce your taxes if you itemize deductions. You pay your mortgage with after-tax dollars, but mortgage interest is usually tax-deductible. The deduction on your mortgage, which for many people is the highest deductible expense, can help you reach the "tipping point," where your itemized deductions exceed the standard deduction that everyone gets. Beyond that number, you can deduct other expenses -- such as property taxes and charitable donations -- that may not add up to enough on their own.
For some homeowners, paying their mortgage off early is more important than investing pretax dollars. Some of them don't get tax savings from their mortgage payments because they don't itemize their deductions or their interest payment is too low, and they value the psychological benefit of being debt-free. Similarly, a homeowner with a high-rate loan can save a small fortune on interest and a load of worry by paying off the mortgage. Paying off a mortgage eliminates the possibility of foreclosure and increases cash flow.
Pretax income can come from a variety of sources, including wages, pensions, self-employment, interest and dividends. Deferring the tax on this income is a strategy that can pay off in the long run. If you're in a high tax bracket now, you can defer the taxes on pretax income by investing in tax-deferred investments and waiting to pay taxes on them until you're in a lower tax bracket, such as during retirement. This strategy can be risky, since no one knows what the tax rates will be in the future.
Investing in tax-deferred accounts puts your tax payments on those funds -- and their earnings -- on hold. These accounts include employer-sponsored retirement plans, traditional individual retirement arrangements, annuities and children's educational plans. Retirement plan investments have other advantages, too. When you die, they pass directly to your beneficiary without going through probate. And if you designate a beneficiary who is a young adult the time of your death, she can "stretch" the tax benefit by waiting to make withdrawals until she reaches retirement age.
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