Tax deductions are great if they are part of your normal spending. But you shouldn’t change your lifestyle or create unnecessary expenses just for the tax deduction - especially if you are not sure if it will even benefit your taxes! For example, if you give to charity because it makes you feel good, then that’s great! But if you do it for tax purposes, make sure that you are able to deduct it and understand that $1 to charity does not equal $1 less of taxes.
I will also point out that this has the ability to change due to the Biden presidency (and any other presidency in the future), but this is where we stand today and how you will file your taxes at the start of next year (for 2020).
Let's break tax “write-offs” / “deductions” into two separate categories, since this is how your tax return does it:
Above-the-line Deductions
Also known as “adjustments to income”, these are deductions that are available to anybody, given it is applicable to their situation and they fit all the rules to claim the deduction. These are expenses that are deducted from your gross income to arrive at your Adjusted Gross Income (AGI), which is also known as “the line”. I want to point out that these are more desired than “below-the-line deductions” as they 1) lower AGI, which other deductions are based on and 2) there is no dollar amount threshold that needs to be met to claim one or more of these deductions.
Here is a short summary of the most common deductions (not an exhaustive list) I’ve seen and some parameters around them:
Educator expenses - if you are an eligible educator and have paid for classroom materials out of your own pocket, you can take a deduction for those expenses up to $250. If your spouse is in the same situation, you can take up to $500 total between the both of you.
Health Savings Account - Also known as an HSA, if you have a high deductible health plan throughout the year, you can contribute to this account. If your employer puts money in your HSA on your behalf, you cannot deduct that since it is never counted as income in the first place. There are no income limits to contribute, but there are contribution limits ($3,550 for single and $7,100 on a family plan in 2020). *Note: if you contributed through payroll deduction, this will be reported on your W-2 and you cannot take this deduction because it was already taken for you.
Deductible part of self employment tax - When you make active income, your income is subject to “payroll taxes” (different from “income taxes”), which is made up of two pieces: social security tax (6.2% of wages up to the wage base of $137,700 in 2020) and Medicare tax (1.45% on all wages) for a total of 7.65% tax liability (assuming you make less than $137,701). What you may or may not know, is that your employer is paying this same tax on your behalf, for total payroll taxes of 15.3% on all your wages up to $137,700; half owed by you and the other half by your employer. When you are self-employed, you are considered both employee and employer in terms of this payroll tax. This means you are responsible for that full 15.3%! Darn. The IRS recognizes that the 7.65% “employer” portion is a deductible business expense which goes here.
Self Employed Qualified Plan - if you are contributing to a self employed retirement plan, you can deduct it here. Note this has its own limitations on how much depending on the type of account and income of your business. This is not the same as an IRA deduction (noted below).
Self Employed Health Insurance - This includes medical, dental and qualified long-term care insurance costs you incurred as a self employed individual. If you have the option to participate in an employer’s subsidized health plan (including your spouse’s plan), this is no longer a deductible expense (even if you choose not to participate).
Alimony - if your divorce was final prior to 2018 and you are paying alimony to your ex-spouse, you may deduct this expense. Any child support payments in addition to or included in this payment is not a deductible expense.
IRA Deduction - there are many caveats to IRA contributions. If neither you, nor your spouse are covered by an employer qualified plan, any contribution you make to a traditional IRA can be deducted. If you or your spouse are covered by an employer retirement plan, the deduction of your contribution may be limited or eliminated depending on your income. Any Roth IRA contributions are not deductible.
Student Loan Interest Deduction - if you have student loans outstanding, you may deduct the interest paid in that year. The amount of interest you paid should be outlined in your student loan account, or your loan servicer will send you a 1098-E at the end of the year (if you paid more than $600 in interest) to detail how much you paid. This has a maximum deduction of $2,500 and your Modified AGI (MAGI) must be under $70k if filing single (these are 2020 limits). MAGI in this case is your AGI assuming you did not take the student loan interest deduction. If you are single and MAGI is between $70k and $85k, the deduction will be reduced, and if your MAGI is greater than $85k, then you will not be able to take a student loan deduction. The income limits for Married Filing Jointly (MFJ) are doubled, although the maximum deduction amount remains at $2,500. If you are married and file separately, you cannot take this deduction regardless of income.
Charitable Contributions (bonus deduction for 2020) - with the passing of the CARES Act, tax year 2020 will allow a $300 above the line deduction for qualified charitable contributions. More information on this below.
As if that list was not long enough, I have one more for you. Form Schedule A breaks down other expenses that may be deducted. The reason these deductions are “not for everybody”, is because the only time you take these deductions is when they add up to be more than the standard deduction, which is $12,400 in 2020 for single individuals and $24,800 for Married Filing Jointly filers. If the Schedule A deductions do not add up to more than the standard deduction, then there was no tax benefit to the expense.
Below-the-line Deductions
Schedule A deductions are known as “below-the-line deductions” or “Itemized Deductions” and have changed and will continue to change as the tax code changes. As we stand today, here are some common deductions:
Medical expenses - these are expenses that you paid out of pocket, were not reimbursed by your insurance, and did not use an HSA or FSA to cover these expenses. There is also a 7.5% “floor” before these start counting. As an example, if your AGI (“the line”) is $100,000, 7.5% of this is $7,500. The first $7,500 of out of pocket medical expenses do not count towards a deduction. In this example, if your out of pocket expenses are $8,000, you may deduct $500 on Schedule A.
Taxes Paid - this includes real estate taxes, personal property taxes and state taxes. For state taxes, you can choose either sales tax paid or state income tax paid (cannot claim both). Sales tax paid is typically done via a formula (unless you had a large expense like a boat or a jet) and I usually only see this in states that do not have an income tax. This whole category is capped at $10,000 whether you file single or jointly. Therefore, if you had $12,000 in Arizona income taxes and $3,000 in real estate taxes, your deduction is limited to $10,000.
Interest you paid - this gets a little dicey, so remember this is just a summary. The two main interest deductions are mortgage interest (includes interest, points and primary mortgage insurance in 2020) and investment interest. Mortgage interest is capped at mortgages of $750,000, and mortgage debt must have been used to improve the house to be able to deduct the interest. If you took out a home equity loan and used it to buy a boat, this is not deductible. Investment interest is deductible up to investment income.
Gifts to charity - This can be cash, securities, goods, etc. given to a qualified charitable organization. There are limits on how much you can deduct depending on a few factors, including your AGI, what you are donating and who or what kind of organization is receiving your donation. These limits are beyond the scope of this blog. Typically, cash contributions are limited to 60% of AGI, but the passing of the CARES Act has increased the limit to 100% of AGI in 2020. The CARES Act has also allowed a $300 above-the-line deduction for charitable donations for those who take the standard deduction as mentioned above. So in 2020, charitable donations continue to be counted as an itemized deduction, but can also be counted as an above-the-line deduction up to $300, but this above-the-line deduction can only be taken if you do not take below-the-line deductions… and you thought taxes were confusing?? Here is a simplified flow chart:
Other Itemized Deductions - there are a few on this list but the most common I see is gambling losses. You can deduct gambling losses to the extent of gambling winnings (yes, you should be reporting your gambling winnings as income).
If all of these items add up to be more than $12,400 if you are single ($24,800 if MFJ), then you should be completing Schedule A! If not, it doesn’t make sense for you to take these deductions and you will take the standard deduction.
Bonus Deduction: Qualified Business Income Deduction (QBID)
This deduction is considered neither above nor below-the-line - it is a deduction from taxable income and is for self-employed individuals and business owners.
Due to corporate tax rates getting cut in the Trump administration, individuals were discouraged from starting businesses outside of a corporate structure. The QBID was created to offset some of this, by allowing a 20% deduction of the lower of Qualified Business Income or taxable income as the general rule. This deduction can change based on taxable income and the type of business. There are many rules involved with this deduction but I wanted to put out there that this should be reviewed if you are a business owner or are self-employed.
Final Thoughts
There are other filing statuses that were not mentioned (head of household, qualified widower, married filing separately) to keep this more concise. It should also be noted that whenever you are claiming the deductions above, adequate receipts will need to be furnished to substantiate your claims if you were ever to be audited.
This article was created to give you a better understanding of how your taxes work and to know what expenses are actually giving you a tax benefit. I know that decisions are never purely financial (there is emotion in almost all decisions) so this is not to urge you to avoid a decision solely because there is no tax or financial benefit. My advice is to understand all the information to make an informed decision. If you want to give to charity because it makes you feel good even though you know there is no tax benefit, power to you.
I am a total DIY-er for many things and I fully support anybody who wants to do that with their taxes. On the flip side, it is not a bad idea to consult a professional or let them do your tax return for a year or two - the cost to do this could make a lot of sense and ensure that you are claiming the correct deductions and credits. Plus, peace of mind with your taxes is priceless!