With consumer debt at record high levels and the national savings rate at a record low, it's no wonder that more and more people are concerned about reducing their debt. The key to trimming your debt is just like any other diet: Cut your spending as you would cut calories and exercise more -- in this case, exercise your self-control.
The similarity to a typical diet regimen doesn't end there: The remedy is often easier to explain than to execute. But once you commit yourself to your goal, there are ways you can use the tax laws to slim down your debts.
The interest you pay on consumer debt falls into two distinct categories: tax-deductible and non-deductible. Mortgage interest and home-equity loan interest are generally tax deductible. So is interest paid on student loans and money borrowed to buy investment property, including stocks, bonds and mutual funds, up to certain limits.
Interest paid on credit cards and car loans is not deductible. In theory, using a home-equity loan to pay off high-interest credit card debt is a good idea. For example, trading $10,000 of 18% nondeductible credit-card debt for $10,000 of 7.5% deductible debt would slice the after-tax carrying cost from $1,800 to $540 a year for a taxpayer in the 28% bracket.
In reality, this strategy works best if you commit yourself to paying down your home-equity debt and claim the tax-deductible interest on your tax return as quickly as possible without allowing your zero-balance credit card statement to entice you to go on another shopping spree. Using your home as a piggy bank has its limits, and even tax-deductible interest cost money.
Home owners rejoice
Tax breaks for homeowners fall into three categories: when you buy, as you own and when you sell. Taking advantage of those tax breaks, and adjusting your tax withholding on your paychecks, or scaling back on your estimated quarterly tax payments if you are self-employed, will give you more money in your pocket each month to apply to your debts.
For most people, buying a home opens the door to a vast array of tax breaks in the form of itemized deductions. In 2008, individuals can claim a basic standard deduction of $5,450; for heads of households, it's $8,000; and for married couples filing a joint return, the standard deduction is $10,900. Homeowners who don’t itemize can boost their 2008 standard deduction by $500 (singles) or $1,000 (marrieds) to account for property taxes they pay.
Stack that up against a homeowner who might have $12,000 in mortgage interest plus $5,000 in local property taxes. In the 25% federal tax bracket, that combined $17,000 tax deduction saves you $4,250 a year. That's more than $350 a month in tax savings that you can apply to paying off your debts.
And once you start itemizing your deductions, you may be able to lower your tax bill even further by writing off charitable contributions, state income taxes and possibly medical bills. More tax savings means more money to pay down debts.