Tax time is here and it seems everyone has questions.
You’ve likely heard of “itemizing” your expenses on your tax return, but we find that not everybody knows exactly what that means, and how exactly “itemizing” affects your tax bill.
Standard deduction versus itemizing
Every year on your tax return, the IRS automatically gives you what’s called the “standard deduction”.
The standard deduction is a set amount that you subtract from your income. It’s an automatic default option and you don’t have to do anything to claim it.
The 2015 standard deduction for single taxpayers is $6,300 and doubles to $12,600 for married filing jointly taxpayers.
So, if you’re single, and your total income is $50,000, the IRS lets you subtract $6,300 automatically, reducing your taxable income by $6,300. Your new taxable income is $43,700 ($50,000 minus $6,300). Your tax bill is now calculated on this lower amount.
Isn’t that special.
But, if you have more “qualified” expenses than the standard amount of $6,300 (or $12,600 if you’re married), it will be more tax advantageous to “itemize”. For example, you’re single and you have $7,500 worth of qualified expenses (more on that below), you can subtract $7,500 from your income instead of only the standard amount.
So you can see how itemizing lowers your taxes by allowing you to subtract a higher level of expenses from your income.
Here is a list of the most common itemized deductions:
1 – Mortgage interest on your primary residence – If you’re paying off a mortgage loan, part of your payment is interest for borrowing money. You’re able to deduct whatever you pay in mortgage interest. However, only the interest is deductible. This can be a big deduction (depending upon your mortgage). Over time, this deduction shrinks as you start to pay off your loan.
2 – Property taxes – Along with having a mortgage, you typically pay property taxes to the county / city where your home is located. These taxes can also be deducted. You can only deduct the taxes that were actually paid to the city / country during the year
3 – State and local taxes – Unless you live in Florida, Texas or 7 other states with no state income tax, you typically pay between 4-6% of your total income in state taxes. These taxes can be itemized on your federal return. Another reason that I am glad I am a TEXAN
4 – Charitable contributions – If you donate to a qualified charitable organization, those donations are an itemized deduction. This includes the value of any clothing, goods, equipment, or even shares of stock that you donate. Check out this handy guide to determine the value of your donated goods for that yearly closet purge and trek down to the Salvation Army or Goodwill.
5 – Un-reimbursed business expenses – Certain un-reimbursed job expenses can be itemized — However, only expenses in excess of 2% of your total income can be itemized in this category. So, it can be hard to cross that threshold.
6 – Medical / dental expenses – Most of you can forget about this one. You can only itemize medical / dental expenses in excess of 10% of your total income. So, unless you have some pretty hefty medical bills, you’re unlikely to cross the threshold.
What are the tax savings of itemizing?
It’s pretty straightforward to calculate the tax savings of itemizing your expenses over taking the standard deduction.
Let’s say you’re single and your effective tax rate is 20%. The standard deduction saves you 20% x $6,300 = $1,260.
If you itemize, every dollar of itemized expenses above the standard saves you $0.20. So, if your itemized expenses total $10,000, your incremental benefit of itemizing = 20% x ($10,000 – $6,300) = $740.
Who should itemize?
So, you’re either going to take the automatic standard deduction, or, if more tax advantageous, you’re going to itemize.
If you know your itemized expenses aren’t going to come close to the level of the automatic standard deduction ($6,300 for single, $12,600 for married), then there’s no reason to even bother tracking your expenses like charitable contributions, medical expenses, etc.
Funny how charities forget to mention that when they ask you for your donation. Your contributions are only tax deductible if you’re already itemizing. (Try using that line the next time you’re harassed in the street and told your donations are tax deductible).
I hope this helps to demystify itemized deductions and gives you a better idea what’s going on behind the scenes with your tax return.
One of the ways we help our clients is by working hard to provide tax-smart investment strategies to minimize the impact Uncle Sam can have on your bottom line. We also consider it our responsibility to educate you about things that could affect your financial future. If you have any questions about your taxes or how tax-efficient planning can help reduce your tax burden, please give us call. We also recommend that you speak with a qualified tax professional who can advise you on the specifics of your personal tax situation.
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