Q&A: What's My Effective Mortgage Interest Rate?

When you sign and initial the hundred or so times required to purchase a home, chances are good that you wind up with a mortgage to go along with the property. That mortgage has an associated interest rate that is used to calculate how much you're charged each month, but it isn't always an accurate measure of how much you pay, in the end. (The mortgage also has an advertised APR that includes points, lender fees, and any applicable PMI thanks to the Truth in Lending Act. Honestly, I've never found the APR that helpful, and it definitely isn't helpful in this discussion - we need to look at the base interest rate.) The net interest you pay depends on your tax situation, and results in what I call your effective interest rate (not to be confused with the more official effective annual interest rate - new name suggestions are appreciated!).

Mortgage interest is tax deductible, which is great in theory, but it doesn't always help very much, if at all. Individuals get a standard deduction of $5,700, and married couples filing jointly get $11,400. If your mortgage interest isn't greater than whatever standard deduction applies to you, then the mortgage interest deduction doesn't help you on its own. You may have other deductions like qualified medical expenses, 401(k) contributions, charitable giving, and the like. If you have a mortgage, chances are good that you have an income and pay state and/or local income taxes, and chances are even better that you have property and are paying real-estate taxes, both of which are deductible. With these deductions, the mortgage interest deduction can be more beneficial.

My medical expenses are well below 7.5% of my adjusted gross income, so those are not deductible. My 401(k) contributions go into a 401(k) ROTH account, so they are not deductible. I have some donations and the occasional miscellaneous deduction, but my main deductions are the state income and property taxes I pay. In the end, most of my mortgage interest winds up being deductible. That means I pay a lot of state and local taxes, though, so that's not entirely a good thing.... It doesn't apply to me this year, but your deduction can also span tax brackets, making the calculation that much more complicated. Some of the deduction may save you 28%, while some may save you 25%, for example.

The amount actually deducted (we can call it the effective deduction until a better suggestion comes in) affects the effective interest rate you pay. For a 5% mortgage with outstanding principal of $200,000, your interest payments will be around $10,000. Say you contribute to a 401(k) and so can deduct all your interest and are in the 25% tax bracket. You effectively reduced the interest paid by 25% * $10,000 = $2,500. You are now paying a net of $7,500 for an effective interest rate of around 3.75%.

Because I'm such a fan of calculators, I just couldn't resist making another one!

Interest Rate (%):
Interest Paid ($):
Interest Deducted ($):
Tax Bracket (%):

Q&A: Roth Versus Traditional

I was recently asked a few interesting (to me) financial questions about 401(k)s, IRAs, and contribution strategies. I've decided to answer those questions in a few Q&A blog posts so everyone can benefit (or get screwed if my strategies aren't sound).

The primary difference of concern between Roth and traditional IRAs and 401(k)s is taxes. Traditional contributions are pre-tax (they are tax deductible), but the distributions are considered as regular income and taxed accordingly. Roth contributions are post-tax, but the distributions are tax-free. So, traditional contributions lower our tax burden now, but increase it later, and Roth contributions raise (or don't benefit) our tax burden today, but lower it later. Another way of looking at it is that traditional contributions are tax-deferred, and Roth contributions include prepaid tax. This gives us two things to think about: our tax bracket now and our expected tax bracket when we start taking distributions.

The general wisdom is that if you expect your income tax bracket to be higher in the future, you should choose Roth retirement accounts. Determining if your tax bracket will be higher can be a complicated question. Personally, I took the following items into consideration when trying to evaluate my future tax bracket:

• Current income - For IRAs, traditional contributions are only tax deductible for those earning less than $53,000 (phased out through $63,000). This made my decision for IRA contributions easy - Roth is still allowed until you make $105,000-$120,000. Traditional 401(k) vs Roth 401(k) still required the following bullet points, too.


• Future income - I've been maxing out my 401(k) and IRA contribution limits since I've been working at IBM. I am on track to have more money coming in than I really know what to do with. I expect my future income to be quite high.


• Current vs. future tax deductions - I can currently deduct mortgage interest, but when I retire, I will not have a mortgage. That's actually my only major deduction at the moment. But, does your employer only offer a traditional 401(k) plan, or have you already decided against the Roth 401(k)? Have children? Taking classes? More deductions that might not apply in retirement!


• Historical tax bracket trends - As you can see from the graph in the link, we are enjoying relatively low tax rates (especially for the rich, which we all hope to be). Does this mean tax rates will rise in the future? Not necessarily, but it wouldn't surprise me.


• National sales tax - I like a lot of the features of a national sales tax instead of an income tax. However, if we go to a national sales tax, our future tax brackets will all be zero percent. After George W. Bush got torn apart for merely suggesting that we look at the plan, I decided a national sales tax isn't too likely to happen, but it's still something to consider.


• Alternative Minimum Tax - The AMT is one of the most complicated set of tax laws out there. It was designed to ensure the wealthy can't deduct their way out of too many taxes, basically. There is some fear that an AMT-like system will be implemented to tax some ROTH distributions that are currently promised to be tax-free. As much as the government loves to tax, I think this, too, is unlikely.

Another thing to consider is how much you will contribute. When you contribute fully, there is an advantage to Roth accounts. Each dollar contributed into a Roth account is equivalent to a pretax contribution plus taxes. Thus, you can make a larger (pre-tax equivalent) retirement contribution via a Roth account. This assumes the same tax bracket now and at retirement, and is definitely not the only consideration. This same type of idea is relevant to estate planning, too. Roth accounts are more valuable, dollar for dollar, than traditional retirement accounts. Retirement accounts are assessed at their account value, not at their after-tax value. A traditional and a Roth account of the same value will be taxed the same amount as part of the estate tax, but the traditional IRA will then have additional income taxes taken out when your heirs take their mandatory distributions.

There are a couple of features that really sold Roth IRAs to me. Because Roth 401(k)s can be converted to a Roth IRA without having to pay taxes when you leave the company, these also end up applying indirectly to Roth 401(k)s! The first feature is that there are no forced distributions from a Roth IRA. You can keep compounding those returns as long as you don't need the money. This gives you a lot more flexibility in your tax and estate planning. The second feature is that Roth IRAs allow you to withdraw the contributions at any time. This makes Roth IRAs a sort of emergency fund - but definitely an emergency fund of near-last resort. Once withdrawn, there is no way of putting that money back in, and you will lose future compounding returns. A better option is probably a 401(k) loan, and a better option than that is probably a home-equity loan (HELOC). Still, it's a nice feature.

As I mentioned in the current income bullet above, only the Roth IRA made sense for me at all. For 401(k)s, there are no income limitations for the vast majority of people. When deciding between a traditional 401(k) and Roth 401(k), or a mix between the two, I looked at the above points and decided that my income is likely to be greater in the future, my tax rate is likely to be higher, and the Roth variety gives me more flexibility later. Still, it is tempting to hedge your future-tax-bracket bet by splitting 401(k) contributions between traditional and Roth 401(k)s. Splitting contributions is allowed, but I have decided against it for the time being for two reasons. First, the Roth 401(k) option has only been offered at IBM as of the beginning of 2008. This means I've already bet two years worth of contributions on traditional 401(k) being better because there was no other bet to make. This year will mark two years of Roth 401(k) betting. Second, employer match contributions have to sit in a traditional 401(k) account. I view these matching contributions as an additional bet on traditional 401(k). Even if you don't view it as a bet, it is at least going to affect your future income levels at retirement and/or when forced distributions kick in at 70.5. Thus, I am maxing out my Roth 401(k) contributions, for the time being.

[For anyone curious, as of the time of this writing, Roth contributions make up 47.19% of my 401(k), and 100% of my IRA.]

In my next post, I will take a look at how tax-advantaged accounts can affect investment choices and how I (plan to) balance my portfolio across my varying accounts to better utilize that tax advantage.

Taxes 2008

This post is analogous to last year's tax post.

Taxes for 2008 turned out to be much simpler than last year for the following reasons:

• I only lived in one state, and so did not need to split my income.


• I closed one of my accounts to pay for the down payment on my house in 2007, so I no longer have to worry about all those forms and trades. That account had tons of trading activity.


• I was familiar with which sites I needed to log in to in order to get various 1099 forms - mainly Countrywide.


• TurboTax imported last year's return so I didn't have as much data entry on my personal information.

I was actually fairly pleased with TurboTax. It still had a few problems (there was no official way to enter short sales [such as cash-secured puts], so I'm not sure I did that right, but the total profits/losses are correct), but was improved from last year overall.

In addition to TurboTax, I used Kansas' WebFile page to e-file my Kansas return. I basically just entered things in line by line from the form TurboTax generated, but didn't have to print it out or mail it. I think that will be the more environmentally friendly route, plus get me my refund sooner.

Speaking of refunds, I get big refunds! From the federal government, I get $5397 back, and I get $854 from Kansas. Governments, you're welcome for the 0% loans over the last year! Please place money in my savings account soon.

What will I do with all that money? Well, you should read this post on things I want to buy, and this post on mortgage refinancing, all while keeping in mind that a cash reserve is nice to have and build.

Why was my refund so large when I owed so much last year? Another list:

• This was my first full year of paying my mortgage, which means a full year of mortgage interest deducted.


• This year sucked for investments, so I had no realized capital gains. I'd rather pay taxes than not be building wealth, though.


• This was my first full year of paying property taxes, which are deductible.

Taxes - What I learned

So, I know I posted a couple entries ago about how I already completed my taxes. Well, that's the first thing I learned.

Always wait until the last day to file your taxes because you never know when your dad will call you up saying that he found one of your tax forms that got delivered to your old permanent address.

Thankfully, I had waited a long time and hadn't actually sent anything off yet. The form in question was a 1099-INT from Bank of America. It took me a minute to realize that my 0% interest checking account did indeed process interest (as opposed to earning it) when I cashed in a bunch of savings bonds my grandfather bought for me in the 80s. In case you were curious, I used it to help pay for the down payment on my house. Anyway, the new final tally (and I really hope it is final, since I sent them off): I owe $3015 to the federal government, and $1416 to Missouri, but get $1117 back from Kansas.

As a side note, the above situation wouldn't have happened if the IRS prepared your taxes and sent the completed forms for you to verify or add addendum forms to.

I also reasoned out a couple of things that always struck me as ridiculously unfair. First, I figured out why state refunds can sometimes be taxed as income the following year. When you itemize your deductions, one of those deductions is the taxes withheld during the year. So, effectively, that refunded money was held by the government for a year, deferring taxes owed on it. It had always seemed to be a double tax on that money, but it does work out to be more fair than I had originally figured. Plus, the same logic applies to deductions: the check to Missouri that I wrote on April 15th will be a deduction on my taxes for 2008.

I actually can't remember what the second thing I reasoned out was. Instead, I'll open it up to comments: Does anyone have any interesting tips, information, or anything else they want to say about taxes?