The Scoring of Tax Breaks

The Relative Value of a Tax Break

Not all tax breaks are created equally. Due to the complexities and nuances of the continually evolving tax code, certain credits and deductions save you significantly more in taxes than others.

Let's look at an example comparing the mortgage interest deduction with the student loan interest deduction. With the high cost of college these days, you can easily owe more than $100,000 in student loan debt upon completion of your degree. On $100,000 of debt, which type of interest saves you more in taxes?

When you have a mortgage on your primary residence, you deduct the full amount of interest paid on up to $1 million of mortgage debt. For your student loans, you are limited to the first $2,500 of interest paid each year. Without even factoring in that you're also required to phase-out this deduction once your Adjusted Gross Income (AGI) exceeds $115,000 if married or $55,000 if single, there is no question that the mortgage interest deduction is a much more valuable tax break than the student loan interest deduction.

Determine Relative Value

Figuring out how to objectively compare tax breaks took quite a bit of thought. To determine the relative value of a variety of tax saving opportunities, we designed our analysis to factor in the following six criteria:

• Type of Tax Break: Credits are more valuable than deductions, and tax-free growth trumps tax-deferred growth.

• The Alternative Minimum Tax: Any deduction or credit limited by the AMT is less valuable—until Congress either fixes or eliminates this tax.

• Expenditure Cap: Most tax breaks limit how much you can spend each year before maxing out the deduction or credit. The lower the annual limit, the lower the relative value.

• Phase-out: Some tax breaks are phased-out based on your AGI, and the value of those tax breaks is reduced accordingly.

• Threshold: Other tax breaks, such as medical expenses and miscellaneous itemized deductions, are only deductible to the extent they exceed a percentage of your AGI. The higher this threshold, the lower the relative value.

• Ease of Reporting: Any tax break that requires you to either complete and attach an additional tax form or to work through a separate worksheet indicates that the rules for this tax break are complicated, impacting its relative value.

Using these six criteria, we calculated a score for each tax break, with a maximum score of 100. Let's take a look at the winners and losers.

The WinnersWhat were some of the attributes that the six winning tax breaks all had in common? None are limited by the AMT. Plus, the amount of the maximum annual expenditures are pretty substantial.

Here are the six tax breaks with a score of 75 or higher:

• Mortgage Interest Deduction — (Score: 75) Full deduction for interest paid on the first $1 million of outstanding debt on your primary residence and second home. Plus, your allowable mortgage interest is deductible when calculating the AMT as well.

• Self-employed Retirement Plans — (Score: 77) Maximum contribution of $46,000 for 2008, which reduces your AGI and is exempt from the AMT.

• 401(k) and 403(b) Salary Deferrals — (Score: 76) Contributions into these employer sponsored retirement savings accounts reduce your taxable wages by up to $15,500 ($20,500 if 50 or older), grow tax deferred, and are unaffected by the AMT.

• Charitable Contributions — (Score: 80) Did you know you can deduct charitable donations of up to 50% of your AGI each year? Plus, like mortgage interest, this itemized deduction is also deductible when calculating the AMT.

• 529 Plans — (Score: 85) Even though 529 plans don't provide for a current year deduction, you and your spouse can sock away up to $120,000 all at once into these tax-free college savings accounts.

• Flexible Spending Accounts — (Score: 75) Through your employer's FSA, you can pay for up to $5,000 of dependent care expenses, and an equal amount of your family's healthcare expenses, with pre-tax dollars.

The Losers

You may be surprised to see the tax breaks that provide the least bang for the buck under the current rules.

• Personal exemptions — (Score: 36) A meager $3,500 (in 2008) for you, your spouse, and each of your children and other dependents. And even though the phase-out threshold is reasonably high, anyone in the AMT loses out on this tax break.

• Savers Tax Credit — (Score: 46) While the government paying you to save for retirement is a great deal, the combination of an annual expenditure limit of just $2,000 and a low phase-out of $52,000 for married couples and $26,000 for single individuals gives this tax break a low value.

• Hybrid Tax Credit — (Score: 41) Not even factoring in that the credit for hybrids manufactured by Toyota and Lexus are fully phased out, and those manufactured by Honda will soon be fully phased out, the fact that this credit isn't allowed if you're in the AMT greatly reduces its value.

• Student loan interest — (Score: 52) Low annual limit of $2,500 coupled with an AGI phase-out starting at $115,000 if married or $55,000 if single gives the student loan interest deduction a low value.

• Interest on An Equity Loan Not Used to Improve Your Home — (Score: 54) While you get to deduct the interest paid on up to $100,000 of your equity loan or line of credit no matter how you spend the money you borrow, not being able to deduct this interest when calculating the ATM if you don't use the proceeds to improve your residence hurts ts value.

Interpreting the ResultsOwn where you live. Max out your retirement savings opportunities. Save for your child's education. Even though the US Tax Code is overly complex, the current set of rules do reward you for make prudent financial planning decisions.

Andrew D. Schwartz, CPA is the founder of The MDTAXES Network, a national network of CPAs who specialize in providing tax services to healthcare professionals. A frequently-quoted tax advisor, his firm of has over 45 years of combined experience specializing in the tax issues affecting healthcare professionals. For more information call 800-471-0045 or e-mail, cpa@mdtaxes.com.