A vacation in the caribbean? A luxury car? Those are all nice. But if there’s one thing everyone really wants is to save on their taxes. And a great way to make this dream come through is by taking advantage of tax deductions.
In this post, we’ll be going through the most common deductions, plus some juicy overlooked ones that will help you get an edge.
But first a quick brief primer on how tax deductions work.
To get your taxable income you first have to calculate your Adjusted Gross Income (AGI). Once you subtract your deductions from your AGI, you arrive at the remaining taxable income.
For federal taxes, you have the choice between the standard deduction, which requires no itemization (less effort) or the itemized deduction. It makes sense to go with the itemized deduction if you keep good records, and you think that it’ll be larger than what would be the standard deduction in your specific situation. For instance, if you’ve incurred a large number of medical expenses in a single year, your itemized deduction may well be larger than your standard deduction.
On top of a tax deduction, you can also get a tax credit. Both reduce your tax liability but in different ways. A tax credit provides for you a dollar for dollar reduction in your tax liability. For example, a $1000 tax credit saves you $1000 in taxes. However, a tax deduction lowers your tax liability equal to the percentage of your marginal tax bracket. For example if you’re in the 25% tax bracket, a $1000 deduction saves you $250 in taxes (25% x $1000 = $250).
Warning: Beware The Floor.
The goal when filing your taxes is to apply as many deductible expenses as possible. This is important because if you don’t exceed a certain amount, then you can’t deduct any expenses that fall under that category. For instance, with medical expenses, you can only deduct them if your expenses in that category exceed 10% of your AGI. So if you have an AGI of $30,000 you can only deduct your medical expenses if they are greater than $3000 in that year.
Tax credits have limits as well but are more obvious. For instance, if you get a tax credit of $0.25 for every $1 you spend on childcare, you may think you’ll get a tax credit of $2500 for spending $10000 on childcare. But not so fast. With further research, you find that this tax credit only applies to the first $3000 you spend on childcare, meaning that even if you spend $10000, you only get a tax credit of $750 (25% x $3000 = $750).
Now, on to our list of the most common tax deductions you can take advantage of during your next return.
1.Health Insurance Premiums Deductions for the Self Employed – Schedule A, Line 1
Running a business comes with some challenging accounting, but you might be able to get some relief with your health care bill if you’re self-employed. If you’re running your own business and qualify for Medicare, you can deduct the premiums you pay for Medicare Part B and Medicare Part D.
But this deduction does not apply if you’re covered under your spouse’s employer’s healthcare plan, or your own employer’s healthcare plan (if you have a job while running a business).
2. Medical Equipment – Schedule A, Line 1
While you can deduct the cost of medical equipment, it may surprise you is what is covered as medical equipment. The obvious ones are capital expenditures as prescribed by a physician, e.g. purchasing an elevator for someone with cardiovascular problems. However, certain unexpected devices have been ruled by the IRS to be medical equipment, for example, breastfeeding apparatus. Take a look and see which health-related equipment is covered as a medical expense.
3. Medical Travel – Schedule A, Line 1
You can deduct the mileage for your travel to and from doctor visits, and also any travel for medical treatment. This can be handy if you’ve been getting regular treatment, and you’re looking to exceed the 10% floor.
4. Reinvested Dividends
Not necessarily a tax deduction, but a subtraction that can save you a lot of money, and which many taxpayers overlook.
If you’re like most investors, you have the dividends from mutual funds automatically reinvested to buy extra shares. This means that each new share purchase increases your “tax basis” in the fund. Your tax basis is the amount it costs you to purchase an investment. The higher your tax basis, the less gain on an investment there is, and therefore the less tax you have to pay.
If you forget to include the reinvested dividends in your cost basis, when you sell your shares, then you’ll have more gains on your investment, meaning you’ll be overpaying on your tax.
Fred Goldberg, the former IRS commissioner, told Kiplinger magazine that millions of taxpayers miss this subtraction, costing US taxpayers millions in overpaid taxes. Do let this be you!
5. Retirement Savings Contribution Credit, Form 1040, Line 51
Saving for retirement is important, so much so that the IRS will give you a tax credit to help you along.
Also known as The Saver’s Credit, this tax credit is designed to encourage low and moderate-income taxpayers to save more for retirement. If you’ve contributed to your 401k, a traditional or Roth IRA, or a retirement plan through work, then you might be eligible.
How much of a tax credit you receive is dependent on whether you match the income requirements. Generally, the lower your income, the greater the credit you can receive, ranging from 10% to 50% of your contribution. The maximum credit amount you can get is $2000 (or $4000 if married and filing jointly). For example, if your filing as a single person with adjusted gross income less than $18,500, and you contribute $1000 to your retirement plan, you’ll get a $500 tax credit.
Use Form 8800 to determine your total credit and your credit rate.
5. Mortgage Points – Form 1040, Line 51
Buying a home is an expensive endeavor. On top of your mortgage, you have to pay points, or loan origination fees, in order to secure the mortgage.
But you can get a deduction on this expense. If you can deduct the points paid to get your mortgage all at one time.
However, if you’re refinancing your home, then you only get to deduct the points over the life of the loan. For a 30 year mortgage, you’d get to deduct 1/30th of the points a year. Better than nothing.
6. Student Loans
Usually, you can only deduct interest if you are legally required to pay the debt. But with student loans, it’s a bit different. If your parents pay back your student loans, the IRS treats this transaction as if the money were given to you and which you used directly to pay the debt. As long as you aren’t claimed as a dependent by your parents, you can deduct $2500 of student loan interest paid by the bank of Mom & Dad.
7. Penalty on Early Withdrawal of Savings – Form 1040, Line 30
Sometimes in an emergency, you need to withdraw your savings, for which you may receive a penalty charge if you don’t give enough notice.
If you had to pay this penalty, then you can deduct it on your 1040.
8. Estate Tax on Income in Respect of a Decedent
If you inherited an IRA from someone whose estate was big enough to qualify for the federal estate tax, then this deduction may save you quite a bit of money.
Let’s say a particularly wealthy individual’s net worth is around $10 million, including a $1 million IRA. As they are over the estate tax exemption $5.49 million, they’ll face an estate tax liability of 40% on the last few million dollars of their net worth, including the IRA.
Yet when the IRA is inherited by its heirs, it counts as pre-tax income for the recipients. This means it’ll be subjected to normal income tax, 39.6% when it’s liquidated.
The result? The IRA is taxed at nearly 80% through a combination of income and estate taxes. A truly demotivating prospect.
To combat this, the beneficiaries (heirs) can get an income tax deduction for any estate taxes created by this pre-tax asset.
Continuing with our example, the $1m IRA causes $400,000 of estate taxes at the 40% marginal estate tax rate. The beneficiaries are then eligible for a $400,000 income tax deduction when they withdraw the IRA funds. With this deduction the beneficiaries only end up owing taxes on the remaining $600,000 which means even at the 39.6% income tax rate, they would face $237,600 of income taxes on the inherited $1 million IRA.
Or in effect, 23.76% income tax on the IRA.
This means in total the beneficiary would owe the 40% estate tax and the 23.76% income tax coming to 63.76% of the estate, not the nearly 80% as before.
9. Property Taxes on a Timeshare – Schedule A, Line 6
Own a timeshare? You might be able to get a deduction. Your portion of the property taxes paid on a timeshare are usually included in your yearly maintenance fee. Check your statement to see if they are separated out; if so, you can deduct them.
Also, if you’ve sold a home or a timeshare in a year, the property taxes already paid on your settlement statement can be deducted.
10. Out of Pocket Charitable Contributions
The big charitable gifts you made, either via check or payroll are easy to spot, and you can deduct them. Those out of pocket costs you sustained while doing charitable work, perhaps buying wool for a community knitting fundraiser or the food ingredients you bought for a soup kitchen add up. You can also deduct 14 cents per mile for any driving you did for charity.
Be creative when it comes to deducting charitable contributions. There are indirect and unexpected “donations” which can be tax deductible. Perhaps you got married at a church or a historical site? You can write off the fee you paid to the venue as a charitable donation. There are many other examples like this, so start brainstorming and check with the IRS for eligibility.
11. Personal Legal Bills – Schedule A, Line 28
If you hired a lawyer to work on securing sources of taxable income on your behalf, do debt collection or even file your tax return, you can use your legal fees as deductions. But this doesn’t count for all legal expenses. For example, you couldn’t deduct your legal fees to gain the custody of a child, but you can deduct any legal fees that go towards securing alimony, as that counts as taxable income.
You can also deduct any legal fees that go towards employment disputes.
12. Job Hunting Costs
If you’re looking for a job in the same field you currently work, you may be able to deduct some costs incurred in your job search.
You can deduct the expenses of preparing and mailing your resumé, the travel expenses incurred in your job search as well as employment agency fees.
These expenses only count if you’re looking for a job in the same line of work as your former job.
13. Moving Expenses for your First Job
You can’t claim job hunting expenses for your first job, but you do get to deduct any moving expenses incurred to relocate to that first job. You don’t even need to itemize to get this deduction.
Your first job must at least be 50 miles away from your old home, and you get to deduct the cost of getting yourself and your stuff to the new area. In 2017 you get to deduct 17 cents a mile if you drive your own car.
14. Child and Dependent Care Credit
Children are expensive. To help offset the costs of childcare, the IRS gives you a tax credit towards your childcare costs.
You can get a tax credit worth 20% to 35% of what you pay for childcare. If you pay for childcare with a reimbursement program via your job, then you get an even better deal, as the money you make through the reimbursement account doesn’t incur federal income taxes, and is protected from the Social Security tax.
This applies to the first $3000 you pay for childcare for one dependent or the first $6000 for two or more dependents.
15. Paying Your Kids A Salary
If you have children who help out with the family business, and you pay them a fair wage, then you may be able to get a tax deduction.
It can be deducted as a business expense from your business income, as well as moving your company’s income from your tax bracket to your children’s, thus reducing your tax burden. You could shift income from as high as a 40% tax bracket to a 0 or 10% tax bracket by paying your children.
16. Lifetime Learning Credit – Form 1040, Line 50
If you’ve taken any extra classes, such as learning a new language, a new skill, or training related to your job, you may be able to deduct any expenses incurred. It’ll qualify for the Lifetime Learning Credit which can get you up to $2000 in tax credits. This credit can be claimed on behalf of your dependents as well. This tax credit cannot be used if your learning is part of an employer tuition reimbursement program.
17. Hobby Expenses – Schedule A, Line 28
If you’ve not been able to generate a profit for a bit of time while building your small business you will not qualify for small business tax deductions. However, you can still deduct some of the expenses you incurred.
If your enterprise runs for three years without a profit, then the IRS classifies it as a hobby, allowing you to deduct expenses as you would with a hobby.
But you can only deduct as much income as you made via your hobby. For instance, if your hobby made you $400 in income, but cost you $2000, then you could only deduct $400 in expenses.
18. Last Year’s State Income Taxes – Schedule A, Line 5a (or 5b)
If you owed state taxes from 2016 and paid it in 2017, you can deduct it from your Schedule A.
You get the choice of deducting state and local income taxes or state and local sales taxes. The latter only makes sense if you live in a state that doesn’t impose an income tax.
You can go to the IRS to see how much you can deduct, based on what state you live in
The key to lowering your tax liability via itemized deductions is in keeping excellent records. Keep all your receipts and track all your expenses. One you’ve kept good records, filing taxes and itemizing your deductions is simple once you break it down.
As Lao Tzu says, “The journey of a thousand miles begins with one step”. Ignore the mountain in front of you and take that first step. Your bank account will thank you.