Everyone loves tax deductions. After all, they reduce your tax liability. But understanding how they work, when you can take them, and how much you save can be quite confusing.
What are Tax Deductions?
In essence, the tax you owe is calculated as a percent of your income, and a tax deduction lowers the portion of your income that is used for this calculation. It’s not a dollar-for-dollar credit, but rather you deduct a percentage of your expense from your taxable income. The lower your income becomes, the less taxes you owe.
As an example, if your tax rate is 20% and you have $100 in income, you would owe $20 in taxes – but with a $20 income tax deduction applied first, your tax is 20% of $80, which is $16.
The Standard Deduction
The IRS offers a standard deduction that every taxpayer can take with no questions asked. You don’t have to prove your expenses or provide receipts. The Tax Cuts and Jobs Act greatly increased the standard deduction amount, making it the more likely deduction taxpayers take. In 2020, the standard deduction is $12,400 for single filers, $18,650 for the head of household, and $24,800 for married filing joint filers.
Itemized Deductions
Itemized deductions are expenses you pay that the IRS allows you to ‘write off.’ Unlike the standard deduction, you must be able to prove these expenses with proper receipts and statements. If your itemized deductions total more than the standard deduction, you are better off itemizing your deductions. Of course, if your itemized expenses are less than the standard deduction, you should opt for the standard deduction and take the easy route.
The most common itemized deductions include:
Mortgage interest paid
You can deduct the interest paid on up to the first $750,000 in home loans. The mortgage can be on your first or second home. The $750,000 limit includes home equity loans, but only if you used the loan to significantly improve your home.
Property taxes paid
You can deduct up to the first $10,000 paid in property taxes. This includes all property, such as your home, car or boat. However, there’s a catch. The IRS combined the property tax deduction limit with your sales and local tax deduction. You may only deduct up to $10,000 combined. If you live in an area with high state income taxes, you may find that you can’t deduct your property taxes.
Charitable contributions
Contributions you make to a qualified charity still count as a deduction. Like any other deduction, you’ll need adequate proof of the expense, especially monetary donations. The Tax Cuts and Jobs Act increased the limit you can deduct to 60% of your adjusted gross income versus the previous 50% limit.
Medical expenses
You may be able to deduct medical expenses paid out of your own pocket if they exceed 10% of your adjusted gross income. This means if your AGI is $100,000, you can only deduct medical expenses above $10,000.
Above-the-Line Deductions
One last deduction type is above-the-line deductions. These deductions directly lower your adjusted gross income. While the benefit of itemized deductions and above-the-line deductions are close to the same, where you really benefit is if you take the standard deduction and above-the-line deductions, as you can do both.
Above-the-line deductions are all deductions taken above the adjusted gross income (AGI) line on your tax form. Some of the most common deductions ‘above the line’ include:
Educator expenses
Teachers can deduct up to $250 spent out of their own pocket for classroom supplies. This applies to all full-time K-12 teachers.
Student loan interest
You may deduct up to $2,500 in student loan interest paid per year. The loan must be in your name and you must be legally obligated to pay it.
Retirement account contributions
If you contribute to a 401K or IRA, you can deduct up to $18,500 and $6,000 respectively.
Self-employment tax
Self-employed taxpayers pay the full amount of the Social Security tax and Medicare tax, rather than the half that employees pay. As an above-the-line deduction, you can claim half of the self-employment tax. While it won’t give you a dollar-for-dollar credit, every little bit helps.
Health Savings account contributions
You can deduct a portion of the amount you contribute to your HSA account. For 2019, the maximum contributions allowed are $3,500 for single filers and $7,000 for those filing married filing jointly.
What Type of Deduction Should you Take?
First, everyone should see what above-the-line deductions they can take. This reduces your AGI right off the bat, which lowers your tax liability. Whether you itemize or take the standard deduction, the above-the-line deduction is valid.
Next, you must consider if you should itemize your deductions or take the standard deduction. An easy rule to use is if your itemized deductions don’t total more than the standard deduction, take the standard deduction. Even if the deduction is close, you may want to stick with the standard deduction. Here’s why.
The standard deduction doesn’t require any proof. Anyone filing takes can take the standard deduction. With the Tax Cuts and Jobs Act, you automatically get a large deduction. Why bother with itemized deductions that you must prove when you can have the $12,400 or $24,800 deduction no questions asked?
Now if your itemized deductions are much larger than the standard deduction and you have proper proof, it’s worth filing Schedule A and taking the itemized deduction.
Check out these tax deduction examples:
Example 1
You are a single filer and your itemized deductions total $11,900. You only have mortgage interest, property taxes, and a few charitable contributions to deduct. You fare better taking the standard deduction. You don’t have the headache of proving your deductions and you can deduct $12,400 rather than $11,900.
Example 2
You are a single filer and your itemized deductions total $25,000. You have mortgage interest, property taxes, charitable contributions, and medical expenses. On top of it, you have above-the-line deductions for student loan interest paid and retirement account contributions. In this case, you’re better off taking the itemized deductions.
Tax deductions help you lower your tax liability. Working with a tax advisor can help make sure you don’t overlook the deductions you may be eligible to take, reducing your liability and putting your money in your pocket.