Tax Deductions: Reading Between the Lines
Tax deductions can lower the amount of income that you end up paying taxes on. We’ll highlight popular above-the-line deductions and below-the-line deductions you may want to consider.
When I first started working in the tax profession, clients would frequently ask me if an expense was a write-off. The expenses ranged from the plausible, such as medical expenses, to the outlandish, such as a vacation in Bermuda.
While write-off is not an actual term used in the tax code, I always knew exactly what my clients were talking about. Their real question was whether or not an expense qualified as a deduction.
A deduction is an expense that reduces the amount of your income that’s subject to being taxed. Note that this is not the same thing as a credit. In contrast, a credit reduces the amount of taxes that you owe. Generally, there are two types of deductions: above-the-line and below-the-line.
Generally, deductions that fall into the above-the-line category are more valuable than ones that are below-the-line. Why? There is no itemization requirement to claim an above-the-line deduction.
Itemize or take the standard deduction—the choice is yours.
When you file your taxes, you have the option of tallying up your deductions yourself and itemizing them, or, you can simply choose to take the standard deduction.
Many people no longer choose to itemize because the standard deduction has almost doubled in 2018 as part of tax reform. The standard deduction in 2018 and onwards for single filers is $12,000, and the standard deduction for those married filing jointly is $24,000. It is estimated that 95% of taxpayers will now take the standard deduction, which gives the above-the-line deductions even greater attention, as you can still receive the additional deductions on top of your standard deduction.
Reduce your AGI—and unlock more potential benefits.
Above-the-line deductions also reduce your adjusted gross income (AGI). This provides an additional benefit, as it could increase your eligibility for credits and/or deductions that are tied to AGI.
For example, your deduction for an IRA contribution could lower your AGI, therefore allowing you to take a deduction for medical expenses because they are allowed as an itemized deduction if they are in excess of 7.5% of AGI for 2018.
Popular Above-the-Line Deductions
- Health Savings Account (HSA) contributions
- Half of your self-employment tax
- Contributions to self-employed retirement plans
- Traditional IRA contributions
- Student loan interest
Above-the-line deductions can also apply to business expenses because they reduce your total income received from the business.
To take advantage of below-the-line deductions, you must itemize your deductions, rather than take the standard deduction.
If you’re able to itemize, you can benefit from additional below-the-line deductions.
Generally, taxpayers must choose to take a standard deduction or itemize their deductions based on whichever is higher. Since the standard deduction has increased in 2018 to $12,000 for single filers, $24,000 for those married filing jointly, it has become substantially more difficult to itemize deductions.
Additionally, as of 2018, the maximum amount you can deduct for state and local taxes is $10,000. This includes taxes on both income and real estate.
Popular Below-the-Line Deductions
- State and local taxes ($10,000 maximum)
- Mortgage interest (on a loan up to $750,000)
- Medical expenses in excess of 7.5% of your AGI (changing to 10% starting in 2019)
- Charitable contributions
- Casualty losses in excess of 10% of your AGI in disaster area federally declared by the president
One Final Below-the-Line Tip
In order to exceed the standard deduction and qualify for itemized deductions, you can make a lump sum charitable contribution either to a donor-advised fund (DAF) or directly to a charity.
Bunching charitable deductions into one tax year may provide a greater tax benefit due to the new higher standard deduction. Since the standard deduction has been increased for a married couple to $24,000, I estimate that the percentage of people who itemize may potentially be reduced from approximately 30% to 5%. For taxpayers who are on the borderline of itemizing, it may make sense to bunch their charitable contributions into one year to help push them over the new higher standard deduction.
Example: Samir is married and has $22,000 in itemized deductions—excluding charity. Samir normally donates $2,000 per year to the Red Cross. Samir may want to donate $4,000 in the current year to push his itemized deductions over the $24,000 threshold, and then he may opt to skip donating the next year. If Samir had maintained course with his $2,000 per year contribution, he would have received no tax benefit.
At Betterment, we offer you the option to donate shares from your taxable account directly to one of our supported charities, as long as the shares are at a long-term gain.
The Gray Area
Most deductions are either above-the-line or below-the-line. However, there are a few deductions that could be either, depending on the circumstances.
For example, real estate taxes on personal property are normally an itemized deduction. However, if the property was converted to a rental, the real estate taxes would become an above-the-line deduction to offset rental income.
Additionally, health insurance that’s paid out-of-pocket is normally an itemized deduction subject to AGI limits. However, if the taxpayer is self-employed, the health insurance is an above-the-line deduction.
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Please note that Betterment is not a tax advisor—please consult a tax professional for further guidance.
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