Let’s face it: Fall is already upon us. By now, the kids are all back in school, the weather is changing (unless you’re here in California), and you’ve likely been enjoying your favorite pumpkin-flavored coffee beverage for a few weeks. Where did the year go?
If you are anything like me, you have begun thinking about doing some basic end-of-year tax planning. If you’re a bit more normal, you might not be thinking about taxes just yet… but perhaps you should.
One of the biggest ways people are able to lower their tax bill is by proper planning and use of tax deductions. Here are some helpful things you should know about the most common deductions available, and what you can do to maximize them before year’s end.
“Above the Line” vs “Below the Line” Deductions
Broadly speaking, tax deductions for individual taxpayers come in two types. These are called above the line and below the line.
So what exactly is this line, when referring to deductions? It’s the actual line on your tax return which lists your Adjusted Gross Income (AGI). For filers of the Form 1040, it is line 37. Those who file a 1040A should look to line 21, and for 1040EZ filers, AGI is on line 4.
Essentially, an Above the Line deduction lowers your AGI, which in turn lowers your taxable income. Aside from being a component of your tax calculation, your AGI can play a significant role in your everyday finances.
For example, having a lower AGI may be advantageous for Federal Government Income Based student loan repayment programs, because payments are calculated using your AGI. On the flip side, having a higher AGI can help with qualifying for a larger mortgage, or other loan, where your income is a factor.
A Below the Line deduction lowers your taxable income, but not your AGI. As you can probably guess, taxable income is the income on which you may be subject to tax. Most of the commonly known tax deductions are below the line deductions.
Itemized Deductions or Standard Deduction
When it comes to below the line deductions, taxpayers have the choice between itemizing (listing out each applicable deduction and dollar amount) or deducting a “standard” amount. Each year the IRS sets the amount of the standard deduction.
You’ll find more info at IRS.gov, but the standard deductions for 2016 have remained the same from 2015. That comes out to $6,300 for single filers and married persons filing separate returns. For married couples filing jointly, the deduction is $12,600.
Contrary to the shoebox-full-of-receipts image that the mention of tax-time may conjure, the truth is that most people do not itemize their deductions.
According to The Tax Foundation, the most recent data available from the IRS (currently for the 2013 tax year) shows that only 30.1 percent of households chose to itemize their deductions (44 million returns). Which means that 68.5 percent of households chose to take the standard deduction (101 million returns).
This is important because a lot of questionable financial decisions have been (and will continue to be) rationalized with some variation of the phrases, “But it’s tax deductible!” or “You can write off the interest.” Going by the Tax Foundation’s statistics, though, tells a different story. We find that 68.5% of the time, the person never actually gets the benefit of said deduction.
Mortgage Interest Deduction
Keeping in mind how few people actually itemize their deductions, let’s take a look at a perennial tax deduction favorite: the mortgage interest deduction.
Back when mortgage rates were in the double digits (anyone remember the mortgage rates of the 1980s?), taking the mortgage interest deduction often made more sense. With today’s mortgage rates back down near historic lows (in the 3% range), the decision becomes a tougher one.
For example, the standard deduction for a married couple in 2016 is $12,600. Assuming that this couple’s only significant tax deduction would be their mortgage interest*, let’s see how much house they would need to buy to make itemizing a reasonable choice.
Let’s assume a 20% down payment, a mortgage interest rate of 3.5%, and a term of 30 years. To make itemization worthwhile, the couple would need to purchase a $456,000 home. At 20% down, they would have a $365,000 mortgage. That’s the minimum needed in order to pay more than $12,600 in interest.
Even with such a high mortgage balance, though, the interest paid in year one would be $12,663.34. This is only $63.34 more than the standard deduction! Even if this couple is in the highest marginal tax bracket (39.6%), the most this deduction would save them in taxes would be $25.08. Hardly worth the trouble, some would say.
Obviously, home values and incomes will vary. Hopefully, this example will provide some food for thought next time you think of buying more house “for the tax savings.”
*Keep in mind that, generally, local property taxes paid on your personal residence can also be deducted along with your mortgage interest. Depending on the local property tax rate in your area, this could make a significant difference in your personal deduction calculation. Due to the incredible variance in local property tax rates, the above example is somewhat simplified and omits local property taxes.
Another tax deduction that springs to mind for most people is the deduction for charitable giving. Snagging a sweet tax deduction is not typically the primary reason people decide to engage in charitable giving. There are a still a few things you should keep in mind if you’d like to make the most of your gift, though.
As with the mortgage interest deduction, the charitable giving deduction is a below the line deduction. You will need to itemize in order to take full advantage of it.
Also keep in mind that, in order to get a tax deduction for your donation, you must be giving to a “qualified organization.” You can use this tool on the IRS website to check if the organization is qualified. Per IRS rules, “you cannot deduct contributions made to specific individuals, political organizations, and candidates.”
For non-cash donations (think stocks, clothing, and household items) you can only deduct the fair market value at the time of donation. This holds true regardless of what you paid for the item.
How To Calculate It: Valuing Your Non-Cash Donations Come Tax Time
For monetary gifts, you “must maintain a bank record, payroll deduction records, or a written communication from the organization containing the name of the organization, the date of the contribution, and amount of the contribution.” -IRS.gov
Student Loan Interest
These days, most new graduates walk the stage with some amount of student loan debt. Here is the silver lining: if your income (Modified Adjusted Gross) is under $80,000 single or $160,000 married, you may be eligible to deduct up to $2,500 of the interest you paid on your student loans. Even better, the student loan interest deduction is an above the line deduction, so no itemization is necessary.
IRS Publication 970 has all the juicy details, should you be curious.
401k and IRA Contributions
Maybe you are looking to really move the needle in terms of reducing your AGI. Here are a couple above the line deductions you may find advantageous.
Maybe you guessed what they are: contributions to certain qualified retirement plans, such as your 401k and traditional IRA. Contributions to 403(b) and 457 plans are also deductible.
For 2016, the limit on tax-deductible contributions to a 401k (for those under 50 years of age) is $18,000. That is a serious chunk of change and gives you a lot of latitude in terms of lowering your AGI, should you take advantage of the high contribution limits. For those 50 and over, the limit is $24,000, as a $6,000 annual “catch up” contribution is also allowed.
The limit on contributions to all your IRAs (traditional and Roth) is $5,500 for 2016 ($6,500 for those 50 and over). Depending on your income, contributions to a traditional IRA are also deductible above the line. Keep in mind that Roth IRA contributions, while awesome, are not tax deductible.
Hopefully, you now have a bit more insight into some of the more nuanced (and fun) aspects of the most common tax deductions. As I mentioned earlier, this time of year is great for enjoying the crisp air, the warm fall colors, and maybe… just maybe… giving some thought to your end of year tax deduction planning.
When do you typically start thinking ahead to Tax Time?There are plenty of deductions still available, but exactly where they’ll appear on your tax return may be different than they have been in the past.
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