Uncle Sam isn't such a bad guy. Yes, a shocking amount of federal taxes are withheld from every hard-earned paycheck you collect, and you might even owe more when April 15 rolls around. But hidden among the 4 million words of the U.S. tax code is a gem of generosity from Uncle Sam called deductions.
Deductions are certain types of expenses that the federal government allows you to subtract from your adjusted gross income (AGI). The more deductions you claim on your income tax return, the lower your taxable income. When you file your taxes each April, you are given a choice of how you want to claim these deductions. The quick and easy way is to claim the standard deduction, a number based purely on your filing status. The 2017 Tax Cuts and Jobs Act, effective for tax year 2018, significantly changed the value and scope of itemized deductions, as you'll see in this article.
Here are the standard deduction amounts for tax year 2018 [source: IRS]
- Single or married filing separately: $12,000
- Married filing jointly or qualified widow(er) with dependent child: $24,000
- Head of household: $18,000
The standard deduction is a nice chunk of change, but if you want to reduce your taxable income even further, you need to itemize your deductions. Like the name suggests, itemized deductions require an item-by-item list of expenses instead of a single lump sum. You can find itemized deductions in dozens of categories, but some of the most common include home mortgage interest paid to your bank, charitable contributions, and state and local taxes paid the previous year.
Congress didn't randomly choose which types of itemized deductions to accept. Some categories of itemized deductions promote socially or economically positive behavior, like home ownership and charitable giving. Others compensate taxpayers for unavoidable expenses and losses, like illness or theft. Still others are just fair: Why should the federal government get to tax you on earnings that you already spent on state and local taxes?
Itemized deductions can save you thousands of dollars in federal incomes taxes, but it's much more complicated than taking the standard deduction. One of the fastest ways to trigger an IRS audit is to claim higher itemized deductions than other people in your tax bracket [source: Eisenberg]. And if the IRS comes knocking, you will need to produce receipts and official documentation for each item on your list.
The best way to learn if itemized deductions are right for you is to speak with a qualified tax preparer or accountant. In the meantime, keep reading for a breakdown of some of the most popular itemized deductions.
Common Itemized Deductions
The IRS has identified dozens of different types of expenses that you can claim as itemized deductions. And if you're the kind of person who enjoys reading poorly translated instruction manuals, check out the full IRS.gov entry on itemized deductions. Otherwise, here are some of the most common itemized deductions claimed by American taxpayers [source: IRS]:
Mortgage interest: The mortgage interest deduction makes home ownership more affordable for millions of Americans. If you buy a home using a traditional 30-year mortgage, the majority of each monthly mortgage payment – at least for the first 15 years – is pure interest on that loan. This generous deduction lets you subtract all of that mortgage interest from your taxable income. You can also deduct premiums paid for mortgage insurance.
State and local taxes: Federal taxes are not the only taxes you pay each year. Most folks pay state and local income taxes, plus local property taxes. Since all of those taxes come out of your gross income, it seems only fair to subtract those totals from your taxable income when calculating federal taxes. Tax reform laws mean that starting in 2018, this deduction is capped at $10,000 [source: Perez]. Note that you can choose to deduct the amount you paid in state and local sales taxes instead of income taxes. This is particularly useful if you live in a state without state and local income taxes (Alaska, Florida, Nevada, South Dakota, Texas, Washington and Wyoming) or you made a large purchase (car, boat, plane) for which you paid a lot of sales tax.
Charitable gifts and donations: You are allowed to deduct the cash value of any gift you made during the tax year to a qualified charitable institution. Gifts can be made in the form of cash donations, property, stocks or anything of real value. Charitable institutions are tax-exempt organizations that include most churches, synagogues and mosques; most nonprofit community organizations like the Boy Scouts, Girl Scouts and Goodwill; most nonprofit colleges and universities; and nonprofit hospitals. For gifts worth $250 or more, you will need a statement from the organization. Note that you can even deduct certain expenses incurred when volunteering for a nonprofit organization. Charitable donations are subjects to limits, which we'll talk about on the next page.
Medical and dental expenses: You can deduct out-of-pocket medical and dental expenses, but only the amount that exceeds 10 percent of your adjusted gross income (there is no longer a lower percentage if you or your spouse is over 65). So if your AGI is $50,000, you can only deduct the expenses that exceed $5,000. If you spent $6,000 on doctor's visits, hospital stays and prescriptions, you can deduct $1,000. You cannot deduct health insurance premiums that were withheld from your paycheck using pretax dollars, but other out-of-pocket premiums are deductible.
Again, these are only the most common deductions. Others include unreimbursed job expenses, theft and casualty losses, tax preparation fees and gambling losses. But before you attempt to write off your entire life, read on to learn about the limits on itemized deductions.
Limits on Itemized Deductions
Here's where itemizing deductions gets a little tricky and where a qualified tax preparer or accountant becomes essential. Congress has generously created many categories of itemized deductions, but there are limits on that generosity. Those limits come in the form of floors, ceilings and phase-outs.
Floors set a minimum amount at which you can start to deduct and ceilings put a cap on how much you can deduct in certain categories.
Common deduction floors:
- As we mentioned earlier, you can only deduct medical and dental expenses that exceed 10 percent of adjusted gross income (AGI).
- There are several miscellaneous deductions that used to fall under the 2 percent rule, meaning you could only deduct the amount within each category that exceeds 2 percent of AGI. Examples included job expenses, tax preparation fees and safety deposit box rentals [source: Sit]. The new tax laws have phased these out for tax years 2018-2025. However, self-employed people can still deduct business expenses via Schedule C [source: TurboTax].
Common deduction ceilings:
- Your total deductions for charitable contributions cannot exceed 50 percent of AGI.
- You can only deduct 50 percent of business-related meal expenses. Expenses incurred in entertaining clients (for instance tickets to a show) can no longer be deducted. If the entertainment for the evening is dinner and a show, they must be purchased separately, otherwise the meal cannot be partially deducted [source: Hertzbach].
- If claiming gambling losses, they cannot exceed your winnings. In other words, you can't gamble away your taxable income at the craps table. However "gambling losses" can now include things such as travel expenses to the casino.
The flip side of the elimination of some of these deductions is that itemized deductions are no longer phased out (gradually decreased) when Adjusted Gross Income is above certain thresholds, (for instance it used to start phasing out at $313,800 for married filing jointly, and $261,500 for single filers.)
Despite the potential tax savings, relatively few Americans itemize their deductions. Read on to find out who does and why.
Who Itemizes Deductions?
Only 30 percent of all federal income tax filers itemized their deductions in 2014, the latest data at the time of publication [source: Greenberg]. For the majority of Americans, the standard deduction offers a better deal than itemizing. They simply don't have enough deductible expenses to add up to more than $12,000 for an individual or $24,000 for a married couple filing jointly.
It's likely that the number of people itemizing will fall since the standard deduction increased so much for tax year 2018 (up from $6,500 for single filers and $13,000 for married filers). One reason Congress gave for doing this was to simplify the tax return, so there would be less need to itemize [source: Tax Foundation].
Itemizing deductions probably makes the most sense to higher-income earners who generally pay more for deductible expenses like mortgage interest, state and local taxes, charitable donations and medical expenses.
A 2017 report by the Congressional Research Service found some interesting data on who itemizes in America:
- Only 17 percent of households earning $20,000 or less itemized in 2014.
- 46 percent of households earning $50,000 to $100,000 itemized their returns.
- 93 percent of households earning $200,000 to $500,000 itemized.
Perhaps not surprisingly, the highest income earners claimed an outsized number of deductions in 2014.
- Households earning $50,000 to $100,000 filed the greatest number of itemized returns (33.6 percent) but only claimed 23.5 percent of total deductions.
- Households earning $250,000 to $500,000 filed 30.6 percent of itemized returns and claimed 28.5 percent of total deductions.
- Households earning more than $1 million only filed 0.8 percent of itemized returns but claimed an outsized 13.1 percent of total deductions.
For lots more information on income taxes and personal financial planning, check out the related HowStuffWorks articles on the next page.
Last editorial update on Jan 17, 2019 01:15:27 pm.
Author's Note: How Itemized Deductions Work
When it comes to filing taxes, I am a walking red flag. First of all, I'm self-employed, which automatically makes me suspicious to the IRS. To make it worse, I claim the home office deduction, I earn some of my income from outside the United States, and I itemize my deductions. I put a lot of trust in tax software to keep me honest and flag any questionable deductions. To be honest, I'm so terrified of an audit that I'm more likely to cheat myself out of deductions than cheat Uncle Sam. Not to mention I make so little money that it's hardly worth the IRS's trouble to hunt me down.
- Eisenberg, Richard. "IRS Audits: Your Odds and Best Strategies." Forbes. April 16, 2013 (Oct. 21, 2014) http://www.forbes.com/sites/nextavenue/2013/04/16/irs-audits-your-odds-and-best-strategies/
- Government Accountability Office. "Further Estimates of Taxpayers Who May Have Overpaid Federal Taxes by Not Itemizing." March 29, 2002 (Oct. 21, 2014) http://www.gao.gov/products/GAO-02-509
- Internal Revenue Service. "Itemized Deductions." (Oct. 21, 2014) http://www.irs.gov/instructions/i1040sca/ar01.html
- Internal Revenue Service. "Limit on Itemized Deductions." (Oct. 21, 2014) http://www.irs.gov/publications/p17/ch29.html
- Internal Revenue Service. "Standard Deduction." (Oct. 21, 2014) http://www.irs.gov/publications/p17/ch20.html#
- Lowry, Sean. "Itemized Tax Deductions for Individuals." Congressional Research Service. Feb. 12, 2014 (Oct. 21, 2014) http://fas.org/sgp/crs/misc/R43012.pdf
- Sit, Harry. "Tax Deductions: Above-the-line, Standard, Itemized, and Miscellaneous." The Finance Buff. Feb. 18, 2009 (Oct. 21, 2014) http://thefinancebuff.com/tax-deductions-above-the-line-standard-itemized-and-miscellaneous.html