There’s an old accountant’s joke about the difference between a legitimate tax deduction and a loophole. A legit deduction is the item you’re claiming. A loophole is the item your neighbor is claiming.
Bonus joke: What’s the definition of a good tax accountant? Someone who has a loophole named after him.
But, seriously: Even after 2017’s game-changing Tax Cut and Jobs Act, the process remains complicated and in many ways perplexing. Moreover, the threat of special scrutiny from the Internal Revenue Service if you (even innocently) misinterpret the rules is worrisome. Nonetheless, no one is obligated to pay more in taxes than is legally due.
Accordingly, then, you should be keenly aware of every deduction and every credit you are due.
First, some useful definitions.
What is income tax?
Income tax is what governments levy on an individual’s earnings each year to pay for the programs and services that government provides. The federal government is expected to take in approximately $3.42 trillion in taxes in 2019 and 49% of that ($1.68 trillion) will be from income taxes, making it the largest source of government revenue.
Not everyone must file taxes. If you are single and make less than $10,400, you don’t need to file. If you are the head of a household and make less than $13,400 you don’t have file.
The rest of us do have to file and it’s there that we start looking for (legal) loopholes in the tax code that allow us deductions so we don’t have to pay so much in taxes to the government.
A deduction is an expenditure you can use to reduce your taxable income, cutting not only your tax bill, but possibly pushing you into a lower marginal tax bracket. Some common deductions are the interest on a home mortgage loan, property taxes, charitable contributions, and certain higher-education expenses.
Consider: For someone who tops out in a 25% income tax bracket, every dollar spent on a legal deduction reduces his/her tax bill by 25 cents.
Using deductions to lower your tax bill requires itemizing, which involves filling out a Schedule A. As recently as last year, anyone paying off a mortgage and, presumably, paying a property tax bill, was a pretty good candidate for the benefits of itemizing.
That changed, dramatically, with passage in December 2017 of the Tax Cuts and Jobs Act, a highlight of which — besides lowering marginal rates — is the near-doubling of the standard deduction, to $12,000 (from $6,500) for single filers and to $24,000 (from $13,000) for joint filers.
In short, if you’re single and your itemized deductions won’t exceed $12,000, you’re better off taking the standard deduction, for the sake of your finances and your time. The Tax Foundation estimates that for taxpayers whose adjusted gross incomes are lower than $200,000, anywhere from 64% to 75% will be better off taking the new, higher, standard deduction.
Calculating Taxable Income
It isn’t easy to calculate how much you owe in taxes because the U.S. government uses what is known as a “marginal tax rate.”
In the marginal tax rate system, the amount of tax is based on income within a specific range – NOT your total income. The percentage of tax applied to your income It goes up progressively from 10% at the bottom end to 37% at the top end based on your earnings and marital status.
For example, if you are single, the first $9,525 you earn, is taxed at 10%. The next $29,174 is taxed at 12%. Any money you earn between $38,701 and $82,500 is taxed at 22%.
So, if you earned $82,500 last year, your income tax (without deductions) would be $14,090.
Contrast that with a married couple filing jointly. They would pay 10% on the first 19,050 they earned. The 12% rate would kick in for earnings between $19,051 and $77,400. The 22% rate applies for income between $77,401 and $165,000.
So, a married couple filing jointly that earned $82,500 last year would pay $10,029.
Again, both of those examples are created without any deductions. You would pay less – sometimes far less! – if you have deductions that reduce the amount of income you get taxed.
What Is a Tax Credit?
A tax credit is a dollar-for-dollar reduction in your tax bill. Though many taxpayers regard it as the same thing as a tax deduction, it is very much not the equal. Tax credits are far more valuable. They directly reduce the amount you pay in taxes and are not dependent on the tax bracket you fall into.
The most coveted tax credits are those that are refundable — that is, filers are rewarded with money from Treasury even if they have zero tax liabilities.
By contrast, nonrefundable credits become exhausted when a filer’s tax bill hits zero.
Popular tax ‘loopholes’
Let’s dive in with some familiar (for veteran itemizers, anyway) and popular — that is, widely used — tax deductions.
- Local and state sales tax is deductible if you don’t claim a deduction for state and local income taxes.
- Property taxes are still deductible, up to a point. Remember all the discussion about SALT before the midterm elections? Property owners and their elected representatives were alarmed that tax reform put a $10,000 cap on the deductibility of state and local taxes (thus, SALT), which promised to whack filers in high-tax states especially hard. … That $10,000 cap also applies to the combination of property taxes and sales taxes, so if your property tax bill is $8,500, and you estimate your sales tax hit at $2,300, you lose $800 of deductible spending under tax reform.
- Mortgage interest: Married and filing jointly? This homeowner perk is still available, but there are new, lower caps. You can deduct interest paid on loans up to $750,000, or $375,000 if you’re filing as an individual.
- Mortgage points: Itemizers can deduct the points (prepaid interest) paid to purchase or build your primary dwelling.
- Home sale: Joint filers can exclude up to $500,000 in profits (that is, the amount paid for their home, plus what they spent on improvements — but not maintenance) from sale of their home; individual filers can exclude up to $250,000.
- Medical and dental expenses: Read the fine print on what qualifies, but, generally, you can deduct the amount of medical and dental expenses incurred by you, your spouse, and your dependents above 7.5 % of your adjusted gross
- Health savings account deposits made by you or someone other than your employer are deductible. Use what’s in your HSA to pay qualifying medical and dental expenses; what you don’t spend in 2018 rolls over into the new year, and, when there’s enough in your account, can be invested. … In 2019, HSA contributions will be limited to $3,500 for individuals, and $7,000 for families.
- Health insurance premiums for self-employed filers: If you worked for yourself, your premiums for medical and dental insurance, plus qualified long-term care insurance, is deductible.
- Traditional IRA contributions are deductible for filers who don’t have an employer-based retirement account. Deduct up to $5,500 in deposits, or $6,500 if you’re 50 or over.
- Contributing to a 401(k) — or a 403(b) or 457 for public-sector employees — reduces your taxable income.
- Tax preparation fees. A caveat: Before the 2017 tax reform, this deduction was available to everyone who itemized. Whether your forms were completed by a professional preparer or you did it yourself with programs such as TurboTax or TaxCut, you were eligible for a deduction. Now the deduction is available only to those who are self-employed.
- Certain conditions apply. For instance, you and your spouse/ex-spouse do not file jointly; payments were made to your spouse/ex-spouse via cash, check, or money order; you are legally separated and live in separate households; child support is not included in your payment.
- Cash donations to IRS-approved charities (so, probably absolutely none of the GoFundMe causes you chipped in on) are deductible, up to 50% of your adjusted gross income. Make certain you can back up your claim with a written record — a bank or credit card statement, or an acknowledgement from the organization will do the trick.
- Noncash donations — household items, clothing, appliances, vehicles, electronics and so on — to qualified nonprofits also are deductible, up to the item’s fair-market value. … Tip: Don’t know what something is worth? Search eBay’s “sold” listings for items similar to your donated stuff.
- Making qualifying higher education tuition or fee payments for yourself, a spouse, or a dependent? This sweet deduction, up to $4,000 (subject to income limits), is available whether you take the standard deduction or itemize.
Credits You Can Use
- Speaking of higher education, filers putting themselves or dependents through college (or other qualifying education program) have a shot at either of two refundable tax credits. The American Opportunity credit equals 100% of the first $2,000 of identified post-high-school education expenses, plus 25% of the next $2,000 (subject to phase-out rules), making the maximum annual credit $2,500. The credit is good for the first four years a student is in college. … The Lifetime Learning credit, useful for part-time students, graduate students, students who’ve used up their four years of American Opportunity credits, and those pursuing training, equals 20% of $10,000 of qualifying education costs, up to $2,000. This credit, too, is means-tested; higher earners will not receive is full advantage. … Read the fine print; restrictions apply. For instance, you can take the deduction, or one of the credits, but not both.
- The Earned Income Tax Credit is designed to reward low-income filers for having jobs and, generally but not exclusively, children. Your income and the number of youngsters in a filer’s household determine the amount of the credit. … The EITC is one of those coveted refundable credits, which, again, means it continues to pay up to the qualified maximum even if you don’t owe taxes. In tax year 2016, almost 26 million working families and individuals received the EITC.
- Child Tax Credit rewards filers with qualifying children, and can be claimed on top of the EITC for child and dependent care expenses. If the youngster is claimed as a dependent, is a U.S. citizen, and lived with you at least half the year, you could qualify for a nonrefundable credit of up to $1,000 (income limitations apply).
Unusual tax deductions
- Home renovations for medical purposes — wheelchair ramps, for instance, or lowering cabinets for accessibility, or handholds — are deductible.
- Investment interest expenses: With limitations, you can deduct the interest paid on money borrowed to purchase taxable investments; the deduction is capped at your net taxable investment income.
- IRA losses: In some unusual cases, you can deduct losses on both traditional and Roth IRAs. For Roth IRAs to qualify, all accounts must be closed, including those that showed a profit.
- Jury duty pay: If you turned over your jury duty compensation to your employer because you continued to be paid your salary while serving, deduct your jury pay from your taxable income.
- Early withdrawal of savings penalty: If you paid a penalty for an early withdrawal from a certificate of deposit, IRA, or similar investment, the penalty may be deductible.
- Volunteer work donations. For instance, if you volunteer for charity work, you can deduct your travel expenses (14 cents per mile in your personal vehicle if you don’t want to track actual expenses, or the cost of public transit), parking, tools bought specially for charity work, or uniforms. Just be sure to get documentation from the charity.
- Bad debts: Made a loan that’ll never be repaid? That’s a bad debt, and it may be deductible. Generally, the proceeds to fund the loan must have come from reported income; you also have to demonstrate you attempted to collect the debt and there’s no chance you’ll be successful.
- Moving expenses for military personnel: This is a big change under tax reform. Previously, anyone who relocated for a job and met IRS tests for time and distance could take a moving-expense deduction. Now only military personnel who move due to a permanent relocation qualify.
- Military reservist travel expenses are deductible for personnel who travel more than 100 miles from home to serve.
- The following used to be available to most employees under certain conditions. Under TCJA, only the self-employed can still deduct car registration fees and job-related car expenses; business travel, including airline baggage fees; professional society membership dues; work uniforms; and home offices.
- Gambling losses remain intact for 2018. If you can demonstrate proof, you may claim losses up to the amount of your gambling income as an “other miscellaneous deduction.”
- Certain disaster losses are deductible only if the loss occurred in a federally declared disaster area.
Be Proactive in 2019
While there are some things you can do to benefit your tax-filing position at the end of the year (donations to charities; rebalancing your investment portfolio so losses offset some of your taxable gains; contributing to an IRA, paying deductible taxes in December even if they come due in the new year), your best bet is to get busy early.
- Do you have fairly predictable medical, vision, and dental expenses? Does caring for your child involve IRS-qualified spending, such as daycare, preschool, or after-school programs? Set up a Flexible Spending Account through your employer. You can deposit up to $2,700, pretax, to spend on qualifying expenses — money you were going to spend anyway. … Check with your benefits counselor about other limitations, but go in knowing, in most cases and with the possible exception of a small rollover, whatever you haven’t spent by Dec, 31 will be lost.
- Don’t have an HSA but your employer offers one? The next time open enrollment rolls around, jump in there. Unused funds roll over, and if you leave your current employer, the account goes with you.
- The saver’s tax credit, or the retirement savings contributions credit, encourages lower-income filers to fund their golden-years nest egg. Depending on your adjusted gross income, the feds will spot you up to a 50% credit for every $1 you put into a qualified retirement account, including your employer’s 401(k) or a traditional or Roth IRA.
- Capital gains — that is, profits taken from securities or other investment assets when they are sold — are, for higher earners, taxed at a lower rate (usually 15-20%) than ordinary income (32-37%). Plan your sales judiciously.
- There’s a reason employer-paid health insurance is among the benefits most coveted by job seekers: Not only are you likely to score better coverage than you could on your own, the IRS does not regard the premiums paid by your employer to be taxable income. Looking for a new position? The job that pays more but offers no health insurance benefit might not offer as much bang for the buck as one that counters a smaller paycheck with benefits.
- Planning to send your offspring to college? Putting your youngsters into private K-12 schools? Look into a 529 saving plan, which lets you deposit money that can grow tax-free. Because deposits are not federally tax-deductible, you can put as much away as you please, or can afford. Same-year tax benefits apply only at the state level; states with income taxes allow, but limit, 529 credits. Check out your state’s allowances and limitations if you have university or private-school expenses looming.
- Thinking of going into business for yourself? Got a spare bedroom you could turn into an office? Lots of tax benefits accrue to those running home-based businesses, ranging from being able to deduct a portion of your monthly household expenses (mortgage, insurance, utilities) to being able to claim depreciation on that portion of your home exclusively dedicated to the business.