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Learning, Sharing, and Teaching => Ask a Mustachian => Topic started by: catmustache on March 08, 2013, 09:59:24 AM

Title: Paying off debt vs. reducing tax bill for baby staches?
Post by: catmustache on March 08, 2013, 09:59:24 AM
Tax season is almost done, but after going through everything, it seems like the government would like me to pay them $500 - 600, which isn't a ton. On the other hand, after calculating out my taxes, if I throw about 2k into a traditional IRA, I could reduce that to about $100. That same 2k could wipe out my husband's credit card debt (11% interest), pay off half my car loan (3% interest, which would eventually lead to highly decreased expenses because I wouldn't have to pay expensive insurance), pay off a small student loan (3% interest) or pay my life expenses for the rest of the month, potentially freeing up future money.

 I'm having trouble with the math.

They way I look at it, right now, I have $2500 in cash, which will pay for taxes + plane ticket. If I put money in the IRA, I have about -1,600 left over (after paying for taxes and the ticket), but I can have the IRA money later in life and if I pay off debts, I have -2500 left over. That calculation only works for the month of March, though and doesn't take into account the impact on the future.

Any thoughts or advice would be greatly appreciated.
Title: Re: Paying off debt vs. reducing tax bill for baby staches?
Post by: FrugalToque on March 08, 2013, 08:45:11 PM
So ...
$2500 cash
$2000 credit card debt (11%)
$????? student loan (3%)
$????? car loan (3%)

I'm not sure where the plane ticket comes in, but priority number one has to be that crazy credit card debt.  That is the Giant Lead Anchor dragging your financial boat to the bottom of the sea.  It has to go first, before you attempt to build a stash or anything else (including, if it were me, a plane ticket, but that plane destination might be some vital family thing, so, hey, what can you do.)

Always, always, always, kill the high interest credit card debt first.  It's like making an 11% ROI, tax-free investment in yourself!
Title: Re: Paying off debt vs. reducing tax bill for baby staches?
Post by: Kazimieras on March 11, 2013, 10:14:46 AM
I'm with the previous poster and pay off your highest costing interest item first. You can't realistically get a 11% return on any investment that is 100%, and by paying off the credit card, you effectively do that. The key is - do not put more money onto the card.

There is nothing wrong with owing the government taxes. It is better to owe them money than have them take it off your paycheque as an interest free loan.

I am a Canadian, so my IRA knowledge is a bit incomplete, however it seems to work similarly to an RRSP, which is basically a tax deferral program. You can put money into it as if it is untaxed, and when you withdraw you are taxed as if it is income. These are great, but all they do is shift when you pay. Given your other debts and their percentages you will be hard pressed to earn something that will exceed the interest rates of your debts - so get rid of those if you can. Once they are wiped out - do not change your spending habits! Just divert all that money you would pay toward debts to saving for retirement.
Title: Re: Paying off debt vs. reducing tax bill for baby staches?
Post by: catmustache on March 11, 2013, 02:23:52 PM
I suppose it makes sense to pay that credit card off first. I really hadn't considered the fact that the same amount (or higher) will get taken out of taxes later on with the IRA, just the decreased credit requirement.

The plane ticket, is, unfortunately, kind of a requirement. My best friend from grade school is getting married and has invited me to be in her wedding party. For her destination wedding. With anyone else, I'd decline, but really can't with her. 

I'll work on that credit card first, and perhaps I'll have an extra 2k after paying that off from somewhere.

Thanks for the input.
Title: Re: Paying off debt vs. reducing tax bill for baby staches?
Post by: FrugalToque on March 12, 2013, 07:18:12 AM
Sounds like a good plan, but please be careful with your taxation assumptions when it comes to IRAs or RRSPs.

Taking Canadian tax brackets as an example, let's say you earn $60k/a.
You'll be paying zero income tax up to about $12k or so, a low tax rate on the income up to about 40k, and a slightly higher rate on the 40k-60k money.
Under our tax laws, you can put 18% of that into an RRSP, so almost $11k
That's $11k of income on which you would have paid the *high* tax rate.  Instead, you put it in an RRSP and pay no tax.  It's as if you only had $9k in the high brackets instead of $20k.

When you take the money out of the RRSP, you'll need less than 40k to live on, so you'll be withdrawing that money at a the *low* tax rate, even though you avoided the *high* tax rate when you put the money in.
Plus, it gets to grow in your RRSP without being taxed.

This is assuming, naturally, that you're living a fairly Mustachian lifestyle where you make more than your earn and intend to retire without SUVs and restricted golf course memberships.