Itemized deductions are an area of significant confusion for many people. We are often encouraged to buy a bigger house or make a donation to a charity because property taxes, interest on a mortgage, and charitable contributions are all “deductible.”
At best, this advice is a case of letting the tax tail wag the dog. At worst, this advice is flat out wrong. Those dispensing this advice often benefit by you taking these actions!
Because this is an area of confusion, it is worth slowing down to understand what these tax deductions are and how they work.
How Do Tax Deductions Work?
Tax deductions reduce the amount of tax you will owe by reducing your taxable income. How valuable your deductions are depends on your marginal tax rate.
The higher your marginal tax rate, the more valuable your deductions. Assume you have $10,000 of deductions. If your marginal tax rate is 37% you would save $3,700.
Those with lower marginal tax rates benefit less from deductions. If your marginal tax rate is 10%, the same $10,000 of deductions would save you $1,000.
Understanding Above The Line vs. Below the Line Deductions
You can categorize tax deductions as:
- Above the Line
- Below the Line
“The line” refers to line 11 on your IRS Form 1040, where Adjusted Gross Income (AGI) is determined. Below the line deductions are what you are concerned with when determining whether to itemize deductions.
However, it is important to understand both types of deductions and the difference between them.
Above the line deductions are valuable for two reasons:
- They reduce your taxable income and are available to all taxpayers, whether you itemize deductions or utilize the standard deduction (more on this below), and
- These deductions lower your AGI. Your AGI, and the closely related Modified AGI, in turn impacts a number of other tax benefits you may qualify for including tax credits. AGI is also part of the calculation that determines how much of your Social Security benefit is taxable.
Below the line deductions are not as valuable as above the line deductions because:
- They don’t lower AGI, and thus don’t offer any secondary benefits, and
- For many people, these deductions are worthless because it is simpler and more beneficial to use the standard deduction.
When Should You Itemize Deductions?
This is a common question with a simple answer. The IRS gives you two options on line 12a of Form 1040:
- Utilize the standard deduction or
- Utilize itemized deductions (from IRS Schedule A)
You should itemize deductions when the benefit of itemizing is greater than the benefit of using the standard deduction. If you don’t do any tax planning, that is all you need to know.
However, with good tax planning you can reduce the amount of tax you pay. More importantly, you can increase the amount of after tax dollars you keep.
Therefore, it is important to understand what the deductions available to you are, how exactly they work, and whether you should develop your plans to optimize these deductions.
In addition to either the standard or itemized deductions, business owners are also entitled to take the qualified business income (QBI) deduction. Like above the line deductions, the QBI deduction is available whether you itemize or not.
The number you get after subtracting these deductions from your AGI is your taxable income.
What Are the Itemized Deductions?
You will find five categories of itemized deductions on Schedule A. Note that the deductions are either capped or they don’t kick in until they exceed a floor.
Due to the restrictions on below-the-line deductions in the current tax code, most people will benefit more by simply using the standard deduction.
Medical and Dental Expenses
Medical and dental expenses are deductible if:
- They are not reimbursed or paid by others AND
- They exceed 7.5% of your AGI.
Assume you have accumulated $20,000 of medical expenses in a year in which you had an AGI of $100,000 and $10,000 of those expenses were covered by medical insurance.
You CAN NOT deduct $20,000. Instead, you can deduct $2,500 of those expenses.
Insurance paid half. You can not deduct those expenses. Of the $10,000 paid out of pocket, only 25% of those exceeded the 7.5% of AGI floor in this scenario.
Expenses paid from a Health Savings Account (HSA) are already tax advantaged. Therefore, those same expenses are also not eligible for a deduction. That would be double dipping on the tax benefits of a single expense. As a general tax rule, that is not allowed.
Taxes You Paid
You can deduct the greater of your local income taxes or sales taxes. Local real estate and property taxes are also deductible. You will see these taxes referred to as SALT (state and local taxes).
Deductible SALT is capped at a total of $10,000. For taxpayers who file married filing single, this is halved to a maximum of $5,000. You cannot deduct amounts over these limits.
Home mortgage interest and points paid on a primary and secondary residence also qualify for below the line deductions. You can also deduct investment interest expenses (generally related to margin accounts and likely not applicable to those who follow the simple investing strategies advocated for on this blog).
There is again a ceiling on how much can be deducted. You can deduct interest on up to a maximum of $750,000 of mortgage debt. Investment interest is deductible up to net investment income.
Gifts to Charity
Gifts to charity are below the line deductions. These deductions are capped at 60% of AGI for gifts of cash to a qualified charity. Gifts of property and gifts to private charities have lower caps.
Personal finance content creators frequently advocate for donor advised funds (DAF). They are pitched as a way to do more good while saving on your tax bill.
You can bundle your charitable donations in one year, made to a DAF, and deduct them in that year. Then you can make distributions from the DAF to qualified charities over multiple years when you use the standard deduction and so wouldn’t get the benefit of a charitable deduction.
This CAN be good advice, particularly if you are still in higher tax brackets when the deduction will be more valuable.
It may be less beneficial for those in early or semi-retirement who have a relatively low AGI and marginal tax rate. Remember your deduction is capped at 60% of AGI.
If your donations exceed 60% of AGI, you can carry your deductions forward. However, that will only help you if you have enough itemized deductions to make itemizing in a future year beneficial. If you use the standard deduction going forward, those carried over deductions will be worthless to you.
Also, remember to determine your marginal tax rate to determine if the extra cost and effort of opening a DAF will provide a commensurate benefit.
Related: Doing Good Better With Your Money
Casualty and Theft Losses
The final category of below the line deductions is included for completeness. It is unlikely that you will ever qualify for this deduction. You certainly can not plan for it.
You can deduct casualty or theft losses if they meet certain criteria. Those criteria include the losses being a result of a “federally declared disaster” and exceeding a threshold of 10% of AGI.
Itemized vs. Standard Deduction
You must choose to utilize either the standard deduction or itemized deductions. You would only elect to itemize deductions if the total itemized deductions exceed your standard deduction.
For married taxpayers, the standard deduction in 2022 is $25,900. It is half that, $12,950, if filing as a single person.
The standard deduction increases for taxpayers over age 65. A married household in which both partners are 65 or older would have a standard deduction of $28,700. Single filers over age 65 have a standard deduction of $14,700.
Quantifying the Benefit of Itemizing
To reiterate, itemized deductions only matter if they exceed the amount of your standard deduction. It is also important to understand how much benefit you get from them.
Your tax savings equal the amount of the difference between the total of your itemized deductions exceeding your standard deduction multiplied by your marginal tax rate.
As an example, assume you are Married Filing Jointly, both less than 65 years year of age, and have $30,000 of itemized deductions in a year. You would have had a standard deduction of $25,900. Itemizing decreases taxable income by $4,100. The amount of tax savings this deduction provides is dependent on your marginal tax rate.
Is the Benefit of Itemizing Worth the Effort?
Consider the benefit vs. the effort, costs, and risk required if you’re weighing the tax implications of decisions such as:
- Buying a more expensive or heavily taxed house vs. a less expensive home,
- Keeping a mortgage vs. paying it off, or
- Bundling charitable contributions into one year in order to itemize vs. donating when you have the money and inclination to do so.
Also consider the increased record keeping required to itemize vs. the simplicity of using the standard deduction.
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[Chris Mamula used principles of traditional retirement planning, combined with creative lifestyle design, to retire from a career as a physical therapist at age 41. After poor experiences with the financial industry early in his professional life, he educated himself on investing and tax planning. Now he draws on his experience to write about wealth building, DIY investing, financial planning, early retirement, and lifestyle design at Can I Retire Yet? Chris has been featured on MarketWatch, Morningstar, U.S. News & World Report, and Business Insider. He is also the primary author of the book Choose FI: Your Blueprint to Financial Independence. You can reach him at firstname.lastname@example.org.]
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