It’s tax time, and deductions can confuse even the savviest Grownup. Not sure if you should itemize deductions when you file your taxes? Don’t panic! Tyler Dolan, CFP®, is here to help.
Fact: Tax season can be stressful. The pressure is on to get tax returns completed and filed by the April deadline. (For 2017, that’s April 18).
As a financial planner, I’ve seen how anxious individual taxpayers can be. Taxes are complicated. There can be a lot of decisions to make. Some should be made before crunch time, such as do I need a CPA? If I decide to do my taxes myself, which online tax service should I use? Then, other questions may come up during the process of preparing your tax return: Should I itemize deductions?
Standard deduction vs. itemized deductions: What’s the difference?
The first step is understanding what each of those transparent IRS terms mean. (Don’t you love tax jokes?)
Both standard and itemized deductions reduce your taxable income. So choosing the higher one typically results in a lower taxable income—and therefore a lower amount of taxes owed. So you’ll want to compare both standard and itemized deductions to see which is more advantageous to you.
The standard deduction is available for everyone to use. Believe it or not, the standard deduction allows every tax filer to have some income that isn’t subject to federal taxation. (Isn’t it surprising the IRS allows that?) The amount is $6,300 for a single filer in 2016, and $12,600 for couples who file jointly. (Yup, both single standard deductions are just combined together.) Choosing the standard deduction is the most popular choice. In fact, almost 70 percent of Americans use the standard deduction on their tax returns.
Itemized deductions are a little more complicated.
You’re required to take inventory and record all your deductions as separate line items. It can be worth the extra effort, though, because itemizing your deductions can allow for a higher deduction than the standard deduction. The itemized list of deductions are captured on the form Schedule A. (It might help you visualize which types of deductions are allowed if you click on that link and follow along.)
Below is a breakdown of the possible deductions you may be able to itemize. Keep in mind there are tons of rules that apply to each of these categories, and some deductions might be limited depending on your situation. But don’t panic! Your CPA or online tax service will be able to figure it out for you.
Itemized deductions could include:
- Unreimbursed medical and dental expenses: Only the amount that came out of your pocket that was unreimbursed. (The IRS says you generally can deduct only the part of your medical and dental expenses that exceeds 10 percent of the amount on Form 1040, line 38—which is your Adjusted Gross Income [AGI]. We’ll get to AGI in a minute.)
- Taxes you paid: Covering state, local, real estate, and property taxes.
- Interest you paid: Home mortgage interest is the big one here.
- Gifts to charity: Gifts by cash, check, or other personal property.
- Casualty and theft losses: Losses associated with your personal property (again, only the amount that was unreimbursed).
- Job expenses and certain miscellaneous deductions: Unreimbursed (yup, that’s a key theme) job expenses, tax prep, and investment-related fees. (The IRS says you can deduct only the part of these expenses that exceeds 2 percent of the amount on Form 1040, line 38, which is your AGI. Keep reading, we’ll get there!)
You can think about the difference between standard and itemized deductions like the different bills you receive at a restaurant or bar. The restaurant copy typically only includes the total (and of course the tip line). That’s like the standard deduction. Your copy will usually include an itemized list of the food and drink you ordered. That’s like the itemized deductions.
Should I use the standard deduction or itemize?
Most of the time the answer is pretty simple: You should use whichever number is higher. Remember what I said earlier: Both standard and itemized deductions reduce your taxable income, and choosing the higher one typically results in a lower taxable income (e.g., lower taxes owed). (I used “typically” on purpose; there are some complicated situations where it makes sense to choose the lower number, but they’re pretty uncommon. If you have a complicated situation, make an appointment with a tax professional for personalized advice.)
To dive in a little bit deeper, it makes sense to boil down part of the federal tax calculation. The most common form used to file federal taxes is the Form 1040. It’s two pages long, has 79 separate line items, and can look downright intimidating at first glance. But it’s not too bad. The form’s job is to calculate how much tax you owe based on your income, then compare that number with how much in taxes you’ve already paid throughout the year.
The first step is to calculate your Taxable Income (see line 43). Don’t let the jargony words scare you away—you can click through to learn more about each term:
After your taxable income is calculated, magic happens to calculate your Taxes Owed. (Just kidding: Your taxable income number runs through the IRS Tax Tables.) Then Credits and Other Taxes are applied to arrive at your total tax. That’s compared to the Tax Payments You’ve Made in order to determine if you get a refund or if you owe money to Uncle Sam.
The standard or itemized deductions live in the Deductions section of the tax return. As you can see from the equation above, a higher deduction amount can result in a lower taxable income, and therefore a lower amount of taxes owed.
As you look at the Schedule A form, think about the categories that may apply to you. Do you own a home? Typically, mortgage interest will push your itemized deductions to be greater than your standard deduction. Did you give a substantial amount of money or personal belongings to charity? (Be honest here. No one wants to get audited.) How about medical expenses? Did you make any medical payments that insurance didn’t cover?
Let’s check out a quick example. Remember, many rules may apply here:
I’ll pretend I’m single, own a home, and made some charitable donations last year. Unfortunately, I didn’t have enough cash to buy my home outright, so I took out a mortgage. And even though this is fantasy land, I have an interest rate on my mortgage. That means a portion of each mortgage payment goes to interest. The total of these interest payments can really add up over the year: Let’s say I paid $7,000 in mortgage interest alone. I also have to pay property taxes on my home. Imaginary town wants their cut, too, so I paid $2,000 in property taxes. I also happen to have some extra cash, $1,000, that I donated to charity.
In this scenario, my itemized deductions add up to $10,000. That’s higher than the $6,300 standard deduction, so it would make sense for me to itemize my deductions.
Why? I’ll show you how each option shakes out. Just to get a general sense of how this works, let’s imagine my tax rate is a flat 25 percent. (This isn’t how it actually works. The IRS makes it far more complicated. But let’s go with it just for an easy example.) We’ll also assume my Adjusted Gross Income (AGI) is $60,350 and I have no kids. (Which means I can take one exemption for myself. One exemption = $4,050 for tax year 2016. If I had one child, I could take two, and so on. No, you can’t take one for your pet. Truth be told: I’ve actually been asked that question!)
|Transparent IRS tax term||If I use the standard deduction||If I itemize my deductions|
|Adjusted Gross Income (AGI):||$60,350||$60,350|
|= Taxable Income:||$50,000||$46,300|
|(x) 25% Tax Rate = Tax I Owe:||$12,500||$11,575|
By choosing to itemize my deductions, I’d save almost $1,000!
Notice that the higher deductions don’t equate to a dollar-for-dollar difference. That is, my deductions are $3,700 higher by using my itemized deductions, but that doesn’t result in $3,700 less in taxes owed. It only saves me $975, meaning I only see 25 percent of that benefit. Credits do equate to a dollar-for-dollar difference. Don’t worry: I’ll delve into the difference between deductions and credits in my next blog post, including a few that are commonly overlooked.
Tyler is a CERTIFIED FINANCIAL PLANNER™ practitioner who believes financial education can empower people to reach their goals.
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While Society of Grownups hopes the information is useful, it’s only intended to provide general education. It’s not legal, tax, or investment advice, and may not apply or be useful to your specific financial situation. If you need recommendations geared to your personal financial situation, schedule time with a financial planner.