Introduction to How Itemized Deductions Work
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.
Here are the standard deduction amounts for tax year 2014 [source: IRS]:
- Single or married filing separately: $6,200
- Married filing jointly or qualified widow(er) with dependent child: $12,400
- Head of household: $9,100
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. 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 (7.5 percent 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) (7.5 percent if you or your spouse is over 65).
- There are several miscellaneous deductions that fall under the 2 percent rule, meaning you can only deduct the amount within each category that exceeds 2 percent of AGI. Examples include job expenses, tax preparation fees and safety deposit box rentals [source: Sit].
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 and entertainment expenses.
- If claiming gambling losses, they cannot exceed your winnings. In other words, you can't gamble away your taxable income at the craps table.
In addition to these limits, Congress has instituted an itemized deduction phase-out for high-income filers. If you file singly and have an AGI greater than $254,200 or file jointly with an AGI greater than $305,050, some of your deductions are subject to limitations: mortgage interest paid, taxes paid, charitable gifts, job expenses and a few miscellaneous expenses. Deductions that are not limited include medical expenses, and casualty and theft losses [source: IRS: Limit on Itemized Deductions and IRS: Inflation Adjustments].
To figure out the dollar value of the phase-out limit requires some math. Your deductions are limited by the smaller of these two amounts [source: IRS]:
- 80 percent of itemized deductions are affected by the limit, or
- 3 percent of the amount by which your AGI exceeds $300,000 if filing jointly, $250,000 if single, or $150,000 if married filing separately
It's called a phase-out because the itemized deduction limit increases with each dollar earned above the AGI threshold up to a maximum amount of 80 percent of total deductions affected by the limit. If you earn enough to qualify for the phase-out on itemized deductions, you can probably afford a good accountant, but it's important to note that the floor and ceiling limits are applied before calculating additional limits for high-income 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 32 percent of all federal income tax filers itemized their deductions in 2011, the latest data at the time of publication [source: Lowry]. 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 $6,200 for an individual or $12,400 for a married couple filing jointly.
In some cases, though, taxpayers mistakenly choose the standard deduction when they could have saved more with itemized deduction. The General Accounting Office analyzed tax returns from 1998 and found 948,000 cases in which people paid Uncle Sam nearly $1 billion too much by failing to itemize.
Looking at the numbers, though, it's clear that itemizing deductions 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 2014 report by the Congressional Research Service found some interesting data on who itemizes in America:
- Only 6 percent of households earning $20,000 or less itemized in 2011.
- 55 percent of households earning $50,000 to $100,000 itemized their returns.
- 94 percent of households earning $200,000 to $250,000 itemized.
Perhaps not surprisingly, the highest income earners claimed an outsized number of deductions in 2011 [source: Lowry]:
- Households earning $50,000 to $100,000 filed the greatest number of itemized returns (36.5 percent) but only claimed 27 percent of total deductions.
- Households earning $250,000 to $500,000 filed 4.4 percent of itemized returns and claimed more than twice that amount (9.1 percent) of total deductions.
- Households earning more than $1 million only filed 0.6 percent of itemized returns but claimed 10.7 percent of total deductions.
The American Taxpayer Relief Act of 2012 reinstated the limit on itemized deductions for high-income earners (known as the Pease limitation) in order to retain more tax revenue from the wealthiest Americans, who are far more likely to itemize.
For lots more information on income taxes and personal financial planning, check out the related HowStuffWorks articles on the next page.