The last couple weeks I’ve been covering the basics of the US Federal Income Tax Return. I’ve broken the return into four basic parts: Filing Status and Dependents, Income, Deductions from Income, and Credits and Payments. The first post provided an introduction and an overview of choosing the right filing status. Last week, I covered how to know what the IRS considers income that must be reported. And now we’ll turn to deductions from income…how to get from your gross income to the (hopefully much lower) taxable income.
The main thing to know about reducing your taxable income is that these reductions typically fall in the category of either Adjustments or Deductions. (Unfortunately, the term Deduction is frequently used to generically refer to items that reduce taxable income, but I’m going to use Deduction here to refer to a specific type of item that reduces taxable income.) Starting from your gross income, you’ll subtract Adjustments, Deductions, and Exemptions to get to your Taxable Income. Exemptions are a fixed amount ($3950 for 2014) that you’re able to deduct for each dependent you claim, as well as for yourself and your spouse (if married, and assuming nobody claims you or your spouse as a dependent). Since exemptions are a straightforward matter of multiplying the annual personal exemption amount by the number of eligible people on your tax return, we’ll just look at Adjustments and Deductions.
Adjustments. These are often referred to by accountants as “above the line” reductions. In this case, “the line” refers to your AGI–aka Line 37 on recent year 1040 Forms. Adjustments reduce your taxable income, much like deductions, but unlike deductions they are not subject to any limitations based on percentage of AGI. Plus you can still take the standard deduction and receive the benefit from adjustments. Because adjustments reduce your AGI, they have some additional benefits as well.
Your AGI determines a number of things. Most importantly, your AGI determines your eligibility for most tax credits and deductions. (And, paradoxically, your AGI can determine your eligibility for adjustments and income reductions–such as Social Security not being treated as taxable–even though these items affect your AGI. It sounds circular, but it’s accomplished through the use of Modified AGI which would require a separate article.) As a result, adjustments can not only reduce your taxable income, but increase other credits and deductions as well.
One relatively common example I’ve seen is reducing your AGI to benefit from the Saver’s Credit, a credit that can be worth 10%, 20%, or even 50% of any amount you contribute to qualified retirement accounts. This credit can be claimed by individuals with AGI below $30,000 and married filing joint couples with AGI below $60,000, so a fairly large number of taxpayers potentially qualify. If you’re just above one of the thresholds for this credit, a reduction in your AGI by, for example, taking an adjustment for qualified tuition and fees might result in a few hundred dollars in savings as a result of the Saver’s Credit now that your AGI is below the threshold–plus the savings from reducing your taxable income.
Adjustments are less restricted than deductions, and they can have added benefits by reducing your AGI. (In fact, in rare cases, I’ve seen adjustments result in tax savings larger than the actual amount of adjustment thanks to this domino effect.) Generally speaking, adjustments are more valuable than deductions.
Deductions. While people most often ask “What can I deduct?” when looking for ways to reduce their tax bill, deductions are actually the least valuable form of tax reduction.
Deductions offer no tax savings at all in many situations. Nearly everybody gets a “standard deduction” they can use to reduce their taxable income automatically (in 2014, this amount was $6200 for Single filers, $12,400 if Married Filing Joint). If your total deductions are less than the “standard” amount, you receive no benefit at all from them because you simply take the standard deduction (with a few rare and minor exceptions). Only when the total of your deductions exceeds the standard deduction do you benefit from “itemizing” your individual deductions and taking that value instead of the standard amount. For most people who don’t have a mortgage, this means they don’t benefit from these deductions–unless they have a lot of other deductions. Furthermore, many deductions are only allowed if they exceed a certain percent of your Adjusted Gross Income (AGI). For medical expenses, only expenses that exceed 10% of your AGI can be deducted. For work-related expenses, investment expenses, and most miscellaneous deductions, only expenses that exceed 2% of your AGI can be deducted. (Expenses in the 2% category can be added together before the 2% reduction, they don’t have to individually exceed 2% of AGI.)
As a result, many people who think they’re going to benefit from a substantial deduction receive no benefit at all, or the benefit is significantly less than they expected.
Other reductions. In addition to Deductions and Adjustments, there are also exemptions (mentioned earlier) and exclusions. Exclusions usually don’t appear on your tax return at all because they are items that aren’t reportable as income in the first place. Employer-provided health insurance is the most common example. The value of health insurance received from an employer doesn’t even show up in Box 1 of the W2 reporting taxable wages. The only exclusion that is sometimes encountered on the tax form is the Foreign Earned Income Exclusion. Because exclusions are rarely seen as income, and the instance where an exclusion does show up on the tax form is so rare, I won’t go into any more detail on exclusions.
So now that we’ve looked at Filing Status, Income, and Reductions from Income, we have enough information to calculate an income tax liability. The income minus any reductions is our Taxable Income. And the Filing Status determines how much tax you pay on that Taxable Income. This leaves just one more area to cover in determining how much you pay, or get back, when you file your taxes. Next week we’ll cover this last area — credits and payments.