Identifying common financial misconceptions

[BPA]

Here are 2 very common misconceptions for Canadians:

RRSP's (Registered Retirement Savings Plan) are a 'Financial Instrument': I bang my head against the wall every time I hear someone talk about "cashing out their RRSP's". They have no clue that an RRSP is a savings plan like a 401(k) that can hold a long list of eligible investments. The RRSP itself is not an investment, it's just a name for a tax-deferred account.

TFSA's (Tax Free Savings Account) are just high interest savings accounts offered by local banks: The TFSA is the Canadian version of a RothIRA. You can invest in just about anything, earn (hopefully) great returns, and never pay tax on those again. Problem is banks in Canada heavily advertise TFSA's throughout the year as a special type of regular savings account and along with that will offer a "generous" 1.5-2% return. So instead of Canadian's using their TFSA's to invest in stocks, they earn a pitiful amount of interest that is even a bit lower than inflation. This, of course, completely wipes out the biggest benefit of the TFSA.

ha ha I say that I will cash out my RRSPs.  I know that the actual investment is in GICs and mutual funds, but for the sake of brevity, I will refer to it as "cashing out RRSPs" when I retire.  Now that I know it drives people a bit batty, I may have more fun with it.  ;)

[Le Barbu]

Talk to anyone who is bad with money for 15 minutes and at least once, maybe twice, the following words will come out of their mouth, "The ____ broke and I didn't have any money so I HAD to put it on the credit card, take a payday loan, etc" like it was some fateful event vs something they should have been prepared for.

And about insurances: good thing my insurances are 0$ deductible! How can someone afford paying a 100$ or a 250$ if shit happen? (me always thinking about my 500$/car and 1,000$/house deductibles make me save hundreds every year)

[Cromacster]

It's been mentioned, but I can't get over people and their deep and abiding love of their mortgage interest tax deduction.

I sent $20K to the bank.  Then I get to deduct the amount over the standard deduction, (depending on what else you have) $15K.  Now I save 20% on that amount ... $3K.  Free money!

Yes, sign me up!

this. As if the standard deduction doesn't exist. And frankly, friends my age who argue for this shouldn't have big mortgages anyway at this late stage in life, for god's sake.

I bought my first house in September (2012), a relatively cheap house.  My deductions as a result of being a home owner did not overcome the standard deduction for that year.  My MIL could not believe we were taking the standard deduction.  Even after I explained it to her she  stood her ground firmly believing that itemizing was what you do when you own a house.

[Le Barbu]

Financing a 25k car @ 0.9% over 84 months is A LOT better than financing a 3,500$ car @ 7% over 6 months

[Copperwood]

It's been mentioned, but I can't get over people and their deep and abiding love of their mortgage interest tax deduction.

I sent $20K to the bank.  Then I get to deduct the amount over the standard deduction, (depending on what else you have) $15K.  Now I save 20% on that amount ... $3K.  Free money!

Yes, sign me up!

this. As if the standard deduction doesn't exist. And frankly, friends my age who argue for this shouldn't have big mortgages anyway at this late stage in life, for god's sake.

I bought my first house in September (2012), a relatively cheap house.  My deductions as a result of being a home owner did not overcome the standard deduction for that year.  My MIL could not believe we were taking the standard deduction.  Even after I explained it to her she  stood her ground firmly believing that itemizing was what you do when you own a house.

hell, she could even look at TurboTax that lets you itemize everything, then still tells you to take the Standard.

[Le Barbu]

Renting is the same as throwing your money trough the window

[Le Barbu]

Houses outside the city are cheap so you can own a bigger one on a bigger lot...

The ______$ you save realy worth the +30k miles/year comute!

Hum, why do you think real estate prices are high in town???

Clue: Rich peoples who are better than you at $$math are willing to pay the prime to buy near the jobs and services. It's just another example of the efficient markets theory

[Jessa]

I have a co-worker who is desperate to take off the rest of his vacation days before this year ends. He is having a hard time getting the days off because he waited until the last minute. He doesn't mind working, so I asked why he doesn't just work the days and get a bonus for having worked extra days at the end of the year. He could retire earlier, or do whatever with the bonus. His reply was that "taxes eat up all the additional pay", so it didn't make any sense to take the pay for those days...


This is based on what happens when you get a big bonus in a particular paycheck. More taxes are withheld so it doesn't look like you got much of a bonus, but the effective rate on the additional pay is simply your highest tax rate based on income, you can easily figure out that rate and know how much the bonus is worth after tax. But he would rather just assume he doesn't get any additional pay from working those days based on the simplistic observation that his "paycheck doesn't seem that much higher after a bonus."

I've heard the same arguement a lot with regards to overtime pay. That after a certain amount of overtime, the government takes so much that it stops being worth it to work the extra time.

My understanding - please correct me if I'm wrong - is that it comes out in the yearly tax filing. So that individual paycheck is taxed as though you make that level of money every paycheck, but when you file your taxes with your actual income for the year, you will get back the difference between what you paid in taxes on that check (presumably a higher tax bracket on a chunk of it) and what you owe in taxes for the year (your normal tax bracket for all of it).

[infogoon]

I bought my first house in September (2012), a relatively cheap house.  My deductions as a result of being a home owner did not overcome the standard deduction for that year.  My MIL could not believe we were taking the standard deduction.  Even after I explained it to her she  stood her ground firmly believing that itemizing was what you do when you own a house.

I think I've posted this before, but our house was inexpensive enough that we did the same thing. Our tax preparer suggested that we should buy a more expensive house so we can itemize.

[Cromacster]

I have a co-worker who is desperate to take off the rest of his vacation days before this year ends. He is having a hard time getting the days off because he waited until the last minute. He doesn't mind working, so I asked why he doesn't just work the days and get a bonus for having worked extra days at the end of the year. He could retire earlier, or do whatever with the bonus. His reply was that "taxes eat up all the additional pay", so it didn't make any sense to take the pay for those days...


This is based on what happens when you get a big bonus in a particular paycheck. More taxes are withheld so it doesn't look like you got much of a bonus, but the effective rate on the additional pay is simply your highest tax rate based on income, you can easily figure out that rate and know how much the bonus is worth after tax. But he would rather just assume he doesn't get any additional pay from working those days based on the simplistic observation that his "paycheck doesn't seem that much higher after a bonus."

I've heard the same arguement a lot with regards to overtime pay. That after a certain amount of overtime, the government takes so much that it stops being worth it to work the extra time.

My understanding - please correct me if I'm wrong - is that it comes out in the yearly tax filing. So that individual paycheck is taxed as though you make that level of money every paycheck, but when you file your taxes with your actual income for the year, you will get back the difference between what you paid in taxes on that check (presumably a higher tax bracket on a chunk of it) and what you owe in taxes for the year (your normal tax bracket for all of it).

Yes, if you look at IRS Pub 15, it contains the tables and methods for calculating payroll withholding.  There are different tables that determine a base amount of how much is withheld, based on pay period and amount.  So if you receive a lump sum bonus or vacation payout it gets bumped into the higher withholding brackets.  But yes, come tax time it will all even out.  Or depending on when you receive the lump sum, you could adjust your withholdings for the remainder of the year.

Ultimately this money is taxed at whatever bracket your income puts you in and will increase your marginal tax rate.  I suppose there may be a point where an individual decides their overtime is not worth the result after tax.  At worst I suppose a person earning 1.5x for overtime could be taxed at 39.6%. so after fica and state they are taking home around 50% of their 1.5x pay.  Which is still much more than 0 if they choose not to work.  Although I would have to assume most people who are in the 39.6% tax bracket are not being paid hourly and receiving overtime pay, but I suppose someone could surprise me and say they are.

[DollarBill]

It's been mentioned, but I can't get over people and their deep and abiding love of their mortgage interest tax deduction.

I sent $20K to the bank.  Then I get to deduct the amount over the standard deduction, (depending on what else you have) $15K.  Now I save 20% on that amount ... $3K.  Free money!

Yes, sign me up!

this. As if the standard deduction doesn't exist. And frankly, friends my age who argue for this shouldn't have big mortgages anyway at this late stage in life, for god's sake.

I bought my first house in September (2012), a relatively cheap house.  My deductions as a result of being a home owner did not overcome the standard deduction for that year.  My MIL could not believe we were taking the standard deduction.  Even after I explained it to her she  stood her ground firmly believing that itemizing was what you do when you own a house.

hell, she could even look at TurboTax that lets you itemize everything, then still tells you to take the Standard.

Just make sure you use the ID-10-T Form...lol

[johnny847]

It's been mentioned, but I can't get over people and their deep and abiding love of their mortgage interest tax deduction.

I sent $20K to the bank.  Then I get to deduct the amount over the standard deduction, (depending on what else you have) $15K.  Now I save 20% on that amount ... $3K.  Free money!

Yes, sign me up!

this. As if the standard deduction doesn't exist. And frankly, friends my age who argue for this shouldn't have big mortgages anyway at this late stage in life, for god's sake.

I bought my first house in September (2012), a relatively cheap house.  My deductions as a result of being a home owner did not overcome the standard deduction for that year.  My MIL could not believe we were taking the standard deduction.  Even after I explained it to her she  stood her ground firmly believing that itemizing was what you do when you own a house.

This probably ties into the general tendency of people buying much more house than they can actually afford, so their mortgage interest is big enough to let them itemize when they also itemize their state taxes and other miscellany.

[johnny847]

I think one of my favorite misconceptions is that of the tax deduction.  Heard someone at work say "just bought a new laptop, but I'm a student and its deductible so I'll get that money back!"  Yikes!

Actually a laptop can be used to qualify for one of the education tax credits which are "above the line" and essentially reduce your taxes dollar for dollar.

Learned something new today!

There is no such thing as an above the line tax credit. Only tax deductions are above the line.

Also, taken from a Turbo Tax article

A computer for school purposes may or may not qualify for these credits. Generally, if your computer is a necessary requirement for enrollment or attendance at an educational institution, the IRS deems it a qualifying expense. If you are using the computer simply out of convenience, it most likely does not qualify for a tax credit.

Neither the institutions that I have attended, nor the ones my friends have attended, have made a computer a requirement for enrollment/attendance. Now of course, I only have a limited data set. But I have my doubts on colleges actually requiring that students have their own laptops, when colleges generally have enough computers in their computer labs.

I believe back in 2009, you could have used a laptop bought for convenience for a student as an expense for the educational tax credit available at the time. But that provision is gone.

[TomTX]

I don't know if this is myth or real, but people tend to think:  Not carrying credit card balances will hurt your credit rating.  What in the name of fuck?  If you had no debt, what the hell do you care about your credit rating for?  What logic is going on here?  "I should pay mad interest monthly so that I can borrow even more in case I ever need it?" 

Whenever the bank tells me that voluntarily lowering my credit limit (that is, I'm asking for them to put it back to sane $5000 levels because they keep jacking the limit), it could 'hurt my credit rating',  I answer, "I don't owe anything and don't plan on doing so. What do I care if it 'hurts' it?  Stab that bastard in the guts for all I care."

The carrying a balance thing is totally bullshit. I had an 850 out of 850 FICO and never carry a balance. I have added new cards since then for better rewards,  so it's probably more lkme 830 now.

[AgileTurtle]

I bought my first house in September (2012), a relatively cheap house.  My deductions as a result of being a home owner did not overcome the standard deduction for that year.  My MIL could not believe we were taking the standard deduction.  Even after I explained it to her she  stood her ground firmly believing that itemizing was what you do when you own a house.

I think I've posted this before, but our house was inexpensive enough that we did the same thing. Our tax preparer suggested that we should buy a more expensive house so we can itemize.

My coworker said their accountant said the same thing. He said his accountant said they should buy a new home that is more expensive because they are paying a lot in taxes. Either that story is a lie or that accountant is not very accountant like.

[AgileTurtle]

It's been mentioned, but I can't get over people and their deep and abiding love of their mortgage interest tax deduction.

I sent $20K to the bank.  Then I get to deduct the amount over the standard deduction, (depending on what else you have) $15K.  Now I save 20% on that amount ... $3K.  Free money!

Yes, sign me up!

this. As if the standard deduction doesn't exist. And frankly, friends my age who argue for this shouldn't have big mortgages anyway at this late stage in life, for god's sake.

I bought my first house in September (2012), a relatively cheap house.  My deductions as a result of being a home owner did not overcome the standard deduction for that year.  My MIL could not believe we were taking the standard deduction.  Even after I explained it to her she  stood her ground firmly believing that itemizing was what you do when you own a house.

I am embarrassed to admit that I didnt realize the standard deduction was so high. I knew it was, just never put much thought into it and believed the righting off mortgage interest thing. I was really surprised after I did the math.

[NoraLenderbee]

Renting is the same as throwing your money trough the window

Yes, in the same way that eating is like flushing money down the toilet. ;)

[Poorman]

There is no such thing as an above the line tax credit. Only tax deductions are above the line.

Also, taken from a Turbo Tax article

A computer for school purposes may or may not qualify for these credits. Generally, if your computer is a necessary requirement for enrollment or attendance at an educational institution, the IRS deems it a qualifying expense. If you are using the computer simply out of convenience, it most likely does not qualify for a tax credit.

Neither the institutions that I have attended, nor the ones my friends have attended, have made a computer a requirement for enrollment/attendance. Now of course, I only have a limited data set. But I have my doubts on colleges actually requiring that students have their own laptops, when colleges generally have enough computers in their computer labs.

I believe back in 2009, you could have used a laptop bought for convenience for a student as an expense for the educational tax credit available at the time. But that provision is gone.

Using the phrase "above the line" was the wrong terminology, but the rest of the comment stands.

Here's a large list of schools that require students to own computer hardware of some kind:

http://www2.westminster-mo.edu/wc_users/homepages/staff/brownr/NotebookList.html

Some schools provide the hardware through grants, but others require students to buy their own, which would qualify for the credit.  Like so many things in the tax code, it depends on the situation of the person doing the buying, and somewhat on the IRS interpretation of the rule.  (For instance, does an online class that requires custom software implicitly qualify even if the student handbook doesn't list the hardware as a requirement?)

[lostamonkey]

Rental properties are an ideal super low risk investments: A friend of mine whose IQ is quite a bit higher than mine bought an rental property in 2 days and did almost no math in the process. He approached me the day before he made the purchase and asked me if I wanted to go 50/50 with him. I obviously said I need to think about it, but he said he wanted to know that same day so I ultimately turned him down. I am glad because I did the math after the fact and it was a pretty shitty investment.

Real estate will never go down: Like other people mentioned, people view owning a home as the ultimate positive financial decision. This is false, and there are many cases where renting and investing the downpayment and your savings every month is a better decision. I am of course ignoring the lifestyle benefits of owning a home.

[irishbear99]

I don't know if this is myth or real, but people tend to think:  Not carrying credit card balances will hurt your credit rating. 

This is actually a myth. I pay off my credit cards in full every month and my score is right around 800. Credit card companies report credit balances once per month to the credit bureaus. If you use your credit card(s) regularly, there's a better than average chance that on the day the credit card reports to the bureaus, you have a balance - even if you pay it in full every month and don't get charged interest.

[johnny847]

There is no such thing as an above the line tax credit. Only tax deductions are above the line.

Also, taken from a Turbo Tax article

A computer for school purposes may or may not qualify for these credits. Generally, if your computer is a necessary requirement for enrollment or attendance at an educational institution, the IRS deems it a qualifying expense. If you are using the computer simply out of convenience, it most likely does not qualify for a tax credit.

Neither the institutions that I have attended, nor the ones my friends have attended, have made a computer a requirement for enrollment/attendance. Now of course, I only have a limited data set. But I have my doubts on colleges actually requiring that students have their own laptops, when colleges generally have enough computers in their computer labs.

I believe back in 2009, you could have used a laptop bought for convenience for a student as an expense for the educational tax credit available at the time. But that provision is gone.

Using the phrase "above the line" was the wrong terminology, but the rest of the comment stands.

Here's a large list of schools that require students to own computer hardware of some kind:

http://www2.westminster-mo.edu/wc_users/homepages/staff/brownr/NotebookList.html

Some schools provide the hardware through grants, but others require students to buy their own, which would qualify for the credit.  Like so many things in the tax code, it depends on the situation of the person doing the buying, and somewhat on the IRS interpretation of the rule.  (For instance, does an online class that requires custom software implicitly qualify even if the student handbook doesn't list the hardware as a requirement?)

Huh. I learn something new every day. Interesting point about the software requirement.

[DaMa]

Quick way to calculate mortgage interest for the month is to divide the rate by 12 (approximate) then multiply that with balance.  That's how much of your payment is interest right now.  For example 3% on $200,000 then .03/12 * 200000 = 500.  The rest of the payment (not including escrow) goes to principal.

[MDM]

Quick way to calculate mortgage interest for the month is to divide the rate by 12 (approximate) then multiply that with balance.  That's how much of your payment is interest right now.  For example 3% on $200,000 then .03/12 * 200000 = 500.  The rest of the payment (not including escrow) goes to principal.

That's not even approximate - it's how it works.

Nice explanation of how to calculate a mortgage payment (other than using Excel PMT) is here: http://en.wikipedia.org/wiki/Fixed-rate_mortgage#Pricing.

[frugalamber]

I have a cw; she is an awesome person, but think, getting low bonus is good as most go into tax. I got bonus more than my remaining RRSP room, so is taking the remaining amount to put in taxable investment and she told me it's actually a loss as I pay higher tax.
I told her, I could rather get the highest bonus possible and pay 30% tax, than underperform for less bonus. She was also the one who told me that you won't get higher performance rating the first year in my job. Proved her wrong there as well.

[Chuck]

I was reminded of another one that has lead to more than one frustrating/heated discussion:

Social Security won't be around when I retire:  Social Security will need to have some adjustments made to it, but assuming there isn't a global catastrophe that dwarfs anything we've seen in modern times, it will be there.  If no changes were made up to the date when the "trust fund" runs out in the 2030's, approximately 75% of benefits could be paid out by the revenue taxes being collected at that point.

That 75% benefit amount will decrease slightly, every year, as the population ages and fewer workers pay in compared to beneficiaries drawing benefits.

SS is a terrible deal. It is likely to get more terrible (higher tax rate or lower benefit payout) so I find it very likely the system won't exist as it does when I "retire" at 62 (or whatever the higher age is then).

[Grid]

i feel like i'm constantly explaining amorization to people who think that 3% interest is constant over the life of the loan and they are paying 3% interest with each payment.  I have pulled out mortgage tables over and over to actually show people when their 3% is actually 3% of their payment.

Could you explain it to me?

I've been under the impression that each mortgage payment includes the interest rate times the principal remaining, plus some amount (equal to the monthly payment minus the amount of interest paid that month) of the principal.  Thus the interest rate is constant over the life of the loan.  What am I missing?

Let's say you have a loan for $100,000 @ 3% in $500 monthly installments.  After month one your balance is $100,250.  On your first payment of $500, you pay $250 in interest and $250 in principal. 

What he's saying is that some people assume that only 3% of that $500 payment is interest - so $475 principal and $15 interest every month.

Thank you so much, you 5th noble gas you.  I knew about "amortization schedules", but it wasn't until you mentioned that the first payment would be exactly $250 in interest in an off-hand manner that I made the connection that THE REASON interest is such a high part of one's first payments is because you're paying interest on such a large amount.  Beautiful.  Now off to yell at my sister who had explained it to me awhile back that the banks do it "just because they want all their interest upfront" and an amortization schedule is something they make up out of thin air.

[Goldielocks]

Misconception:  That, for the same tax rate, there is a difference between investing small amounts in traditional vs. Roth accounts.
Truth:  Roth = A * (1 - T) * (1 + i)^n
            trad = A * (1 + i)^n * (1 - T)
A = amount invested
T = tax rate
i = annual investment return
n = years invested
Either way, the amounts are identical.

Misconception: That, for maximum contributions, there is no difference between traditional vs. Roth accounts, even for the same tax rate.
Truth: In this case, Roth is better.  See http://www.bogleheads.org/forum/viewtopic.php?f=10&t=140758 (among others) for details.


One may have to read the above items carefully....

My head is spinning now.  Maybe I misunderstand Trad versus 401k formats.
I am from Canada.  I always think of a traditional IRA like a personal 401k  (like our RRSP but with penalties) and a Roth IRA like a TFSA.

I don't get the statement above --"even for the same tax rate".   For most employed people (earning more than $60k per year), the tax rate of these investments is never the same?

Isn't a traditional Roth much, much better due to the income tax refund, versus a Roth IRA? -- at least until your traditional IRA gets too big and would behighly taxed on withdrawl?

[lizzie]

It's been mentioned, but I can't get over people and their deep and abiding love of their mortgage interest tax deduction.

I sent $20K to the bank.  Then I get to deduct the amount over the standard deduction, (depending on what else you have) $15K.  Now I save 20% on that amount ... $3K.  Free money!

Yes, sign me up!

this. As if the standard deduction doesn't exist. And frankly, friends my age who argue for this shouldn't have big mortgages anyway at this late stage in life, for god's sake.

I bought my first house in September (2012), a relatively cheap house.  My deductions as a result of being a home owner did not overcome the standard deduction for that year.  My MIL could not believe we were taking the standard deduction.  Even after I explained it to her she  stood her ground firmly believing that itemizing was what you do when you own a house.

I am embarrassed to admit that I didnt realize the standard deduction was so high. I knew it was, just never put much thought into it and believed the righting off mortgage interest thing. I was really surprised after I did the math.

We paid off our house this year, and all these comments I've seen around here lately about the standard deduction prompted me to go back and look at last year's tax return to see whether it will still make sense to itemize. Hell, state income and property taxes alone put us about $5,000 over the standard deduction. We also had a tax guy a few years ago recommend that we buy more house. :/

[seanc0x0]

And also that the cash vs credit (what makes you spend more) is a fair or useful comparison. The comparison is not cash vs. credit. It's about limits. Typically cash is fairly limited, whereas the credit is not, or has a much higher limit. If you think you spend more if you use credit compared to cash, try walking around with $5000 of cash in your wallet (or whatever your credit limit is) and see how you spend then. The more you have to spend, regardless of method, the easier spending is. If you need a clear limit in order to spend less money, then go for it - use a small amount of cash. But don't buy into the myth that it's the payment method that is helping here.

So what about people like me, who will quickly blow through their (limited) $20 cash, but not waste $20 of their $2,000 credit limit? For some people, the method DOES make a difference.

Hear, hear! I see I have $20 left in a budget category on mint, I'm not likely to spend it. If I have that $20 in my pocket, eh, whatever, it's already a sunk cost in my budget software - at least, that's what happens to me.

You're right. I was generally thinking about the reverse "myth" that people spend less if they use cash. In my own life, I'm usually the same as you two - cash is easier to spend

I'm in the same boat. I hate using cash. Not only is it easy to spend (or lose!), it doesn't leave a trail to help you figure out where it went. I've got $35 in my wallet right now, but according to YNAB, I should have $68.  Where's the rest?  Who knows! 

Though, looking at it, it was June last time I reconciled my cash balance, so overall, I'm not that far out. Still pretty annoying, though.

[MDM]

Misconception:  That, for the same tax rate, there is a difference between investing small amounts in traditional vs. Roth accounts.
Truth:  Roth = A * (1 - T) * (1 + i)^n
            trad = A * (1 + i)^n * (1 - T)
A = amount invested
T = tax rate
i = annual investment return
n = years invested
Either way, the amounts are identical.

Misconception: That, for maximum contributions, there is no difference between traditional vs. Roth accounts, even for the same tax rate.
Truth: In this case, Roth is better.  See http://www.bogleheads.org/forum/viewtopic.php?f=10&t=140758 (among others) for details.


One may have to read the above items carefully....

My head is spinning now.  Maybe I misunderstand Trad versus 401k formats.
I am from Canada.  I always think of a traditional IRA like a personal 401k  (like our RRSP but with penalties) and a Roth IRA like a TFSA.

I don't get the statement above --"even for the same tax rate".   For most employed people (earning more than $60k per year), the tax rate of these investments is never the same?

Isn't a traditional Roth much, much better due to the income tax refund, versus a Roth IRA? -- at least until your traditional IRA gets too big and would behighly taxed on withdrawl?

We'll start with some definitions.  See http://www.smart401k.com/Content/retail/resource-center/retirement-investing-basics/retirement-plan-types for more details, but in short
401k: Work-related tax-advantaged account with $17,500 contribution limit
IRA: Work-independent tax-advantaged account with $5,500 contribution limit

There are rules about the types and amounts of income that make one eligible or not for these plans (the point of Undecided's reply #3) but we'll ignore those for now.

The point that (I hope) will stop the head-spinning: both 401k and IRA plans come in two flavors:
1.  Traditional (so-called because this is how they were first established): contributions are deducted from income now, and tax (at whatever rates apply in the future) is paid when withdrawn.
2.  Roth: no tax savings now, but all future withdrawals (including investment gains) are tax free.

The correct choice of flavor requires one to know the tax savings one would get today from a Traditional account, vs. the tax savings one would get in the future from a Roth account.  The Traditional vs. Roth comparison should be done using the top marginal rates the investor pays, both now and expected in retirement. 

See http://www.bogleheads.org/wiki/Traditional_versus_Roth for the much longer version.

The phrase "even for the same tax rate" refers to the before- and after-retirement tax rates discussed in the previous paragraph here.

There is, alas, no such thing as a "traditional Roth".  Unless one considers a Health Savings Account (HSA)....

Better - or spinning faster?

ETA: Clarify use of marginal rate in Trad vs. Roth comparison.

[SU]

The difference between maximising after tax income v minimising tax, which is behind all of the ridiculous suggestions to buy more house/cash flow negative businesses/IT equipment 'for the tax deduction'.

If you are paying more tax, it's because you have more income. Well done!

*assuming you've taken advantage of all tax concessions related to retirement accounts. 

[EDSMedS]

I hate using cash. Not only is it easy to spend (or lose!), it doesn't leave a trail to help you figure out where it went. I've got $35 in my wallet right now, but according to YNAB, I should have $68.  Where's the rest?  Who knows! 

DW found $33 working at her landscaping job today...  thanks for your donation!

[Goldielocks]

Misconception:  That, for the same tax rate, there is a difference between investing small amounts in traditional vs. Roth accounts.
Truth:  Roth = A * (1 - T) * (1 + i)^n
            trad = A * (1 + i)^n * (1 - T)
A = amount invested
T = tax rate
i = annual investment return
n = years invested
Either way, the amounts are identical.

Misconception: That, for maximum contributions, there is no difference between traditional vs. Roth accounts, even for the same tax rate.
Truth: In this case, Roth is better.  See http://www.bogleheads.org/forum/viewtopic.php?f=10&t=140758 (among others) for details.


One may have to read the above items carefully....

My head is spinning now.  Maybe I misunderstand Trad versus 401k formats.
I am from Canada.  I always think of a traditional IRA like a personal 401k  (like our RRSP but with penalties) and a Roth IRA like a TFSA.

I don't get the statement above --"even for the same tax rate".   For most employed people (earning more than $60k per year), the tax rate of these investments is never the same?

Isn't a traditional Roth much, much better due to the income tax refund, versus a Roth IRA? -- at least until your traditional IRA gets too big and would behighly taxed on withdrawl?

We'll start with some definitions.  See http://www.smart401k.com/Content/retail/resource-center/retirement-investing-basics/retirement-plan-types for more details, but in short
401k: Work-related tax-advantaged account with $17,500 contribution limit
IRA: Work-independent tax-advantaged account with $5,500 contribution limit

There are rules about the types and amounts of income that make one eligible or not for these plans (the point of Undecided's reply #3) but we'll ignore those for now.

The point that (I hope) will stop the head-spinning: both 401k and IRA plans come in two flavors:
1.  Traditional (so-called because this is how they were first established): contributions are deducted from income now, and tax (at whatever rates apply in the future) is paid when withdrawn.
2.  Roth: no tax savings now, but all future withdrawals (including investment gains) are tax free.

The correct choice of flavor requires one to know the tax savings one would get today from a Traditional account, vs. the tax savings one would get in the future from a Roth account.  If one has other sources of income in retirement then the Traditional vs. Roth comparison can be done using marginal rates.  If these withdrawals are the only income in retirement, then one has to look at "marginal rate when working" vs. "overall rate when retired".
See http://www.bogleheads.org/wiki/Traditional_versus_Roth for the much longer version.

The phrase "even for the same tax rate" refers to the before- and after-retirement tax rates discussed in the previous paragraph here.

There is, alas, no such thing as a "traditional Roth".  Unless one considers a Health Savings Account (HSA)....

Better - or spinning faster?

Thanks,  very clear definitions.
My error, I did indeed mean, traditional IRA...

Your explanation (with handy clarification on the limits) is exactly what I thought, until this part...

The phrase "even for the same tax rate" refers to the before- and after-retirement tax rates discussed in the previous paragraph here.


If you are a high income earner (over $60k per year), and plan on retirement income of under $75k, then your tax deduction NOW, is on a much higher marginal rate than your net tax rate in FUTURE upon retirement.   

Therefore a 401k or a traditional IRA is by far your best first place for retirement accounts --- UNTIL YOU EXPECT TO WITHDRAW MORE THAN $75K/yr  (or whatever the mathematical magic number is)
And a Roth IRA is a place for "extra" monies over your contribution limit.

I can't see any time that the "same tax rate" would normally apply to both Roth IRA and Traditional IRAs...   Unless you earn only a little now, and expect a lot in future.  (Not common).

Can you explain a bit further how or when the "same tax rate" would occur?

[MDM]

Your explanation (with handy clarification on the limits) is exactly what I thought, until this part...

The phrase "even for the same tax rate" refers to the before- and after-retirement tax rates discussed in the previous paragraph here.

Let's take these from the bottom up.

I can't see any time that the "same tax rate" would normally apply to both Roth IRA and Traditional IRAs...   Unless you earn only a little now, and expect a lot in future.  (Not common).

Can you explain a bit further how or when the "same tax rate" would occur?

"Having a pension" and "just starting work at a low wage and expecting good career prospects" are two situations in which a person might have the same marginal tax rate both while working and in retirement.  Also, because tax brackets can be wide, one could have a decrease in income yet still be in the same marginal tax bracket.  Might not be common, but probably not rare.

And a Roth IRA is a place for "extra" monies over your contribution limit.

Not sure to which limit you refer.  It is certainly true that traditional IRAs have lower maximum income (for allowed tax deduction) than do Roth IRAs, despite (or, considering politics, perhaps due to) a traditional IRA being of more value to someone with high income.

Your point about traditional being better than Roth if your tax rate will drop is correct.  Similarly, Roth would be better if tax rates are expected to increase.

The answer is less clear when equal tax rates are expected. 

For smaller contribution amounts the commutative property of multiplication applies and it truly doesn't matter.  When one can contribute the maximum amount, however, it turns out Roth is better.  The bogleheads thread I linked has one of the better discussions about this. 

There is enough uncertainty in one's estimation of future vs. present tax rates that the mathematical niceties covered in the bogleheads thread are likely to be of more academic than practical import.  But it does fit the thread title here.... ;)

[dragoncar]

It's been mentioned, but I can't get over people and their deep and abiding love of their mortgage interest tax deduction.

I sent $20K to the bank.  Then I get to deduct the amount over the standard deduction, (depending on what else you have) $15K.  Now I save 20% on that amount ... $3K.  Free money!

Yes, sign me up!

this. As if the standard deduction doesn't exist. And frankly, friends my age who argue for this shouldn't have big mortgages anyway at this late stage in life, for god's sake.

I bought my first house in September (2012), a relatively cheap house.  My deductions as a result of being a home owner did not overcome the standard deduction for that year.  My MIL could not believe we were taking the standard deduction.  Even after I explained it to her she  stood her ground firmly believing that itemizing was what you do when you own a house.

I am embarrassed to admit that I didnt realize the standard deduction was so high. I knew it was, just never put much thought into it and believed the righting off mortgage interest thing. I was really surprised after I did the math.

We paid off our house this year, and all these comments I've seen around here lately about the standard deduction prompted me to go back and look at last year's tax return to see whether it will still make sense to itemize. Hell, state income and property taxes alone put us about $5,000 over the standard deduction. We also had a tax guy a few years ago recommend that we buy more house. :/

My state taxes blow away the standard deduction too.  With a marginal rate of 42.3%, I have a deep and abiding love of the mortgage interest deduction.  Reason #3726 california real estate is so expensive

[Sid Hoffman]

That renting is always "throwing money away". Because home ownership has no lost costs - it's pure profit/savings, didn't you know?

Actually I've struggled with that very topic myself, now that I lost my home via divorce.  I'm currently renting and I'm not even sure when to buy a house.  It's odd because I started to realize that although I want an owned home to be just right I am willing to put up with more garbage in a rental.  Why?  Because it's not my problem.  If it breaks, I call the property manager and they need to fix it.  If they give me trouble then on average, I am 6-months away from being able to move out and try someplace else instead.  In a pinch, you can walk away from a rental and simply take the hit on your reference list or not list that place at all.

So for me, the math worked out like this:

(All figured are adjusted for inflation. This means rent stays the same, home value stays the same after inflation, and return rate is after inflation)

Renting: $1100/month, then the overage goes into perhaps an index fund, lets say it does 4% above the rate of inflation over 30 years.  Let's say the overage in this case is $900/month.  Let's also say I started out with $40,000 in savings, for reasons explained below.  After 30 years I'd have spent $396,000 on rent (ouch!) and have saved $324,000 plus the initial $40,000.  My compounding calculator says it would be worth about $759,000.  If I then purchased a $200k home for cash, I'd have $559,000 and a paid off home.

Owning: A similar home to the rental in a condition I would enjoy would be around $200,000, $1600/year in property taxes & insurance, $50/month HOA, and about $120/month of maintenance.  With 20% down, that means my initial $40,000 has been used up, but then I have a 30-year mortgage at 4% for a monthly PITI of $764.
PITI: $764
Tax & insurance: $133
Maintenance: $120
HOA: $50
Total: $1067/month, leaving $933 for savings.
With investing $933/month of savings at the same 4% ROI I'd have $649,700 and a paid off home.

While home ownership looks more attractive on the surface, what it ignores is that most people move an average of once every 7 years and you give up potentially upwards of 8% of the home's value each time you move between realtor commission, closing costs, and loan origination fees on the new home, even if you do manage to time it pretty tightly so you're not carrying two mortgages at the same time for long.  8% of $200k 4 times is $64,000.  I've known people who only moved 4 times in 40 years, but I've also known people who moved 18 times in 20 years.  My math above assumes 0 moves in 30 years.

Also, my maintenance projection of $120/month is just to keep the house functional, really.  You can't do very much in the way of updating flooring, appliances, or anything else.  It would be enough to keep a builder-basic home functional, IMO.  I base that on 15 years of home ownership and feel it's fair, but anyone else is free to adjust as they see fit.

Bottom line was that even for a VERY long-term rental outlook (30 years is longer than many people can see themselves renting) the end result wasn't terribly different as long as the renter is disciplined enough to truly put their rental savings into investments.  What I tend to see however is that people who rent simply don't save either.  Owning a home is a way to attempt to force people to save.  Still, even that doesn't work terribly well as I regularly talk to people who take out home equity loans every time they get a chance to, or do debt consolidation by running up lots of car loans & unsecured debt, then rolling it into a home refinancing to pay off the consumer debt by resetting their mortgage to no equity.  I know at least one 60 year old who's always been a homeowner, never rented and yet only has about $80k equity in their $250k home.

[Posthumane]

-Myth: You should get married so that you can split your income to save on income tax. There is no general income splitting between working couples in Canada, with a couple of exceptions.

Now (2014) couples in Canada can split incomes for tax purpose. Don't have to be "married" do.

Old thread, been away for a bit, but I wanted to comment on this. Couples without children still do not have any income splitting options if both are working. The new income splitting rules are only for households with children under 18 so far as I can tell.

[Goldielocks]

-Myth: You should get married so that you can split your income to save on income tax. There is no general income splitting between working couples in Canada, with a couple of exceptions.

Now (2014) couples in Canada can split incomes for tax purpose. Don't have to be "married" do.

Old thread, been away for a bit, but I wanted to comment on this. Couples without children still do not have any income splitting options if both are working. The new income splitting rules are only for households with children under 18 so far as I can tell.

What year does it come into effect?  I did not realize it was in place yet, thought it was still just talk.

[Posthumane]

According to articles from October when it was announced it is supposed to take effect in tax year 2014, so if it applies to you then I believe you should be putting it on your forms now (or in the next couple months, whenever you file). It's called the family tax cut. Maximum benefit for a family is $2k.

http://www.cra-arc.gc.ca/gncy/bdgt/2014/qa10-eng.html

[Le Barbu]

-Myth: You should get married so that you can split your income to save on income tax. There is no general income splitting between working couples in Canada, with a couple of exceptions.

Now (2014) couples in Canada can split incomes for tax purpose. Don't have to be "married" do.

Old thread, been away for a bit, but I wanted to comment on this. Couples without children still do not have any income splitting options if both are working. The new income splitting rules are only for households with children under 18 so far as I can tell.

I dont see this anywhere in the link you mention (which paragraph?) just curious because we got 2 kids, so the split apply to us.

[hunniebun]

The idea that if you buy something on sale you have "saved money" when in fact you just spent money.

+1

My mother in law will drive 30 minutes to a nearby city to Sears and arrive at 7 am to get a 10$ cash card and buy something on sale.  Not identifying that she just spend more than 10$ in gas 1.5 hours in time to buy something that she didn't need for 25% off. Not saving a thing.

[Posthumane]

-Myth: You should get married so that you can split your income to save on income tax. There is no general income splitting between working couples in Canada, with a couple of exceptions.

Now (2014) couples in Canada can split incomes for tax purpose. Don't have to be "married" do.

Old thread, been away for a bit, but I wanted to comment on this. Couples without children still do not have any income splitting options if both are working. The new income splitting rules are only for households with children under 18 so far as I can tell.

I dont see this anywhere in the link you mention (which paragraph?) just curious because we got 2 kids, so the split apply to us.

It's under the 5th bullet "Can I claim the Family Tax Cut?" it has a list of requirements, one of which is as follows:
-You have a child who is under 18 at the end of the year who ordinarily lives throughout the year with you or your eligible spouse or common-law partner;

Also, under the first bullet the description of the family tax cut reads:
The October 30, 2014 announcement included a proposal to introduce the Family Tax Cut, a new non-refundable tax credit of up to $2,000 for eligible couples with minor children based on the net reduction of federal tax that would be realized if up to $50,000 of an individual's taxable income was transferred to the individual's eligible spouse or common-law partner. This would take advantage of a spouse's lower income tax bracket.

The only benefit for couples without children is if there is a spouse who is not working (i.e. has income less than $11138). The higher earning partner can claim a tax deduction for their dependent spouse equal to $11138 minus the spouse's income (including dividend income).

[Goldielocks]

According to articles from October when it was announced it is supposed to take effect in tax year 2014, so if it applies to you then I believe you should be putting it on your forms now (or in the next couple months, whenever you file). It's called the family tax cut. Maximum benefit for a family is $2k.

http://www.cra-arc.gc.ca/gncy/bdgt/2014/qa10-eng.html

Happy dance... even if it is years since it was promised.

[Le Barbu]

-Myth: You should get married so that you can split your income to save on income tax. There is no general income splitting between working couples in Canada, with a couple of exceptions.

Now (2014) couples in Canada can split incomes for tax purpose. Don't have to be "married" do.

Old thread, been away for a bit, but I wanted to comment on this. Couples without children still do not have any income splitting options if both are working. The new income splitting rules are only for households with children under 18 so far as I can tell.

I dont see this anywhere in the link you mention (which paragraph?) just curious because we got 2 kids, so the split apply to us.

It's under the 5th bullet "Can I claim the Family Tax Cut?" it has a list of requirements, one of which is as follows:
-You have a child who is under 18 at the end of the year who ordinarily lives throughout the year with you or your eligible spouse or common-law partner;

Also, under the first bullet the description of the family tax cut reads:
The October 30, 2014 announcement included a proposal to introduce the Family Tax Cut, a new non-refundable tax credit of up to $2,000 for eligible couples with minor children based on the net reduction of federal tax that would be realized if up to $50,000 of an individual's taxable income was transferred to the individual's eligible spouse or common-law partner. This would take advantage of a spouse's lower income tax bracket.

The only benefit for couples without children is if there is a spouse who is not working (i.e. has income less than $11138). The higher earning partner can claim a tax deduction for their dependent spouse equal to $11138 minus the spouse's income (including dividend income).

Thanks

I think in my case, the split will increase the refund by +/- 1,500$, I'll take it to invest, more

[rocketpj]

Related to the topic of mortgages, I was reminded of the biweekly mortgage payment plan.

Misconception:  Using a biweekly mortgage payment plan saves you money due to the partial payment being made before the full payment is due.  Almost all of the reduction in time to payoff of the mortgage is because by paying biweekly you're making 13 payments per year (52 weeks/2 = 26 biweekly payments*0.5 mortgage payment = 13 mortgage payments per year).

It may still be a useful way to pre-pay your mortgage if it's easier to match up with you pay period, but you'd get almost all of the benefit by making one extra mortgage payment at the end of the year.

I think this might vary between banks, or at least countries.  My understanding of our biweekly payments (as explained to me by my banker) is that they save money by reducing the principle 2 weeks earlier than otherwise, as well as the extra total payments in a year.  Regardless it saves money, so if I am wrong it isn't the worst kind of misconception to have.  Simple shifting to biweekly (on my payday) has shaved years off our mortgage, without any additional payments.

[Astatine]

The worst and most common one I've come across:

When getting a mortgage (from a bank or mortgage broker or whoever), the maximum amount you get approved for is affordable and a good idea. Cos it's the banks, right? They know what they're doing.

Whereas in reality, the two times I've been approved for a mortgage, yes I could technically afforded the amount, but there was no wriggle room for error, and I would have had to live as frugally as when I was living well below the poverty line. No thank you.

Sadly, people do accept what the banks tell them they can afford to borrow. Argh. So so wrong.

[Le Barbu]

Related to the topic of mortgages, I was reminded of the biweekly mortgage payment plan.

Misconception:  Using a biweekly mortgage payment plan saves you money due to the partial payment being made before the full payment is due.  Almost all of the reduction in time to payoff of the mortgage is because by paying biweekly you're making 13 payments per year (52 weeks/2 = 26 biweekly payments*0.5 mortgage payment = 13 mortgage payments per year).

It may still be a useful way to pre-pay your mortgage if it's easier to match up with you pay period, but you'd get almost all of the benefit by making one extra mortgage payment at the end of the year.

I think this might vary between banks, or at least countries.  My understanding of our biweekly payments (as explained to me by my banker) is that they save money by reducing the principle 2 weeks earlier than otherwise, as well as the extra total payments in a year.  Regardless it saves money, so if I am wrong it isn't the worst kind of misconception to have.  Simple shifting to biweekly (on my payday) has shaved years off our mortgage, without any additional payments.

What realy save money (interests) is to fit payment with your pay day (deposit). Whatever if it´s weekly, bi-weekly, monthly, semi-monthly etc.

If one's pay comes in once a month, he save no dime to set mortgage payment every 2 weeks

[RetiredAt63]

Just paying 2 weeks early does not do much.

GoodStash BadStache is right.  The trick is to make 13 monthly payments in the year, not 12 - somehow.  So take 1/2 a month's payment and pay it every two weeks (so you made 26 payments, not 24).  Or take the annual amount and divide by 26 and pay that twice a month.  Or add 1/12 of your monthly payment to each monthly payment.  The details don't matter much, what matters is paying that extra month each year.  We paid off a 25 year mortgage in 19 years that way, many years ago.  Nothing else, just that.  It probably helps a bit to do it over the year instead of a lump payment at the end of the year - but a lump payment at the beginning of the year should be better.

This is what spreadsheets are for - you can set up different scenarios and see what has the best payoff that works with your budget.  Banks in different countries may calculate payments a bit differently, but if you know how your bank does it, it doesn't really matter what others do.

Related to the topic of mortgages, I was reminded of the biweekly mortgage payment plan.

Misconception:  Using a biweekly mortgage payment plan saves you money due to the partial payment being made before the full payment is due.  Almost all of the reduction in time to payoff of the mortgage is because by paying biweekly you're making 13 payments per year (52 weeks/2 = 26 biweekly payments*0.5 mortgage payment = 13 mortgage payments per year).

It may still be a useful way to pre-pay your mortgage if it's easier to match up with you pay period, but you'd get almost all of the benefit by making one extra mortgage payment at the end of the year.

I think this might vary between banks, or at least countries.  My understanding of our biweekly payments (as explained to me by my banker) is that they save money by reducing the principle 2 weeks earlier than otherwise, as well as the extra total payments in a year.  Regardless it saves money, so if I am wrong it isn't the worst kind of misconception to have.  Simple shifting to biweekly (on my payday) has shaved years off our mortgage, without any additional payments.

[deborah]

Or take the annual amount and divide by 26 and pay that twice a month.

I'm sure your bank wouldn't like this!

[RetiredAt63]

??  "I'm sure your bank wouldn't like this!"
That is the classic calculation for paying a mortgage off fast without pain.  I learned that back in 1978.  We did it, bank was fine with it.   One way or another, get 13 payments done in 12.  Of course they would rather people do the traditional payment schedule.

Other options - I expect to have a chunk of money come in sometime in the next year or two - when I renewed my mortgage, I went for three year open instead of 5 year fixed, so I will have no penalty in paying off a huge chunk when that money comes in. Plus interest was lower, and I kept my payment the same, so my amortization period shortened (more to principal since less to interest).  Benefits - I can convert to fixed any time I want (if interest rates start a climb)  Since it is prime plus a %, when the Bank of Canada dropped its rate by 0.25% and the banks followed by dropping their prime by 0.15%, my interest went down.  My projected pay-off date just advanced by 4 months. 

But the point is, my "go-to" person at my branch and I worked this out together, I didn't have to raise any kind of fuss.  Mind you, we both knew there were 4 other major banks with local branches that would happily give me a mortgage if I didn't like what my bank had to offer.  If you know your options and the arithmetic, you should be able to get the mortgage terms you want.

Or take the annual amount and divide by 26 and pay that twice a month.

I'm sure your bank wouldn't like this!