Beware the illusion of a tax deduction

When you are finishing up your taxes this year, take a hard look at your deductions, and look below the surface. It used to be simple, you either had a deduction or you didn't. Today, Uncle Sam regularly gives with one hand and takes away with the other, and you may not even realize it. Worse, you may be making financial decisions based on some faulty assumptions.

Let's take that most popular of deductions, the mortgage interest deduction. Personal finance columns routinely recommend not paying off your mortgage, because the interest is tax deductible. But, unless you have a very large mortgage, large charitable deductions or astronomical medical or miscelaneous deductions, your mortgage interest is probably not really deductible. It disappears because the standard deduction is larger than your itemized deductions. Even if you itemize, it is likely that most of the interest is not reducing your taxes, since you are only slightly over the standard.

I'd guess the mortgage deduction applies to only a small percentage of filers, and only marginally to many of them. But, this is just the tip of the iceberg. Medical expenses are deductible, right? Only to the extent they exceed 7.5% of your income(read very rarely). Miscellaneous deductions, such as professional fees, are deductible only to the extent they exceed 2% of your income. IRA contributions are deductible, right? Only to the extent your income is below certain limits. The same goes for tuition payments. The list goes on and on, with deductions being ruled out by income limits or minimums. I haven't been able to take any of these deductions for 25+ years, and yet they remain out there, tantalizing promises unfulfilled.

Then, of course, there is the Alternative Minimum Tax (AMT). Enacted to keep the rich from escaping taxes by using tax deductions, it was not indexed. It also was not included in the Bush tax cuts. As a result, it is beginning to significantly affect the middle class by eliminating their deductions. Your contributions are deductible, right? Maybe not, with AMT. You itemize, so your mortgage interest is deductible, right? Maybe not, with AMT. Your outrageous state taxes are deductible, right? Maybe not, with AMT. Even non taxable income, such as municipal bond interest, can become taxable with AMT.

I won't go more into AMT, since there are many articles out there that address the issues in detail. Just be aware that what appears on the surface to be positive because of the tax implications, may not be, these days. It pays to take a look below the surface of your tax return and analyze them, to see how it could effect your financial decisions this year. You may be surprised that the smart tax move turns out to be an illusion, leading to less than optimal decisions.