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Plan Well, Retire Well

Saving and investing your money

Deductible Expenses: Bah, Humbug!

Contrary to all the news items with tips for maximizing your income tax deductions for 2011, I'm a bit of a Scrooge on the subject. Here's why: you may not be getting the tax benefits you think you are.

There are several reasons that you might not get the tax benefit you expect:

1) Your itemized deductions, (the ones claimed on Schedule A) don't add up to more than the standard deduction for your filing status. Unless you have a) mortgage interest, b) significant property taxes, c) large charitable donations, and/or d) really large medical expenses, you will probably end up taking the standard deduction. Result? You got no tax benefit from those expenses.

The standard deductions for 2011 are:

  • Single or Married filing separately $5,800
  • Married filing jointly or Qualifying widow(er) with dependent child $11,600
  • Head of household $8,500
  • A person claimed as a dependent on another person's tax return $950 or more, depending on earned income

2) For certain categories, you can only deduct expenses that exceed a floor amount. Only those medical expenses that exceed 7.5% of your AGI (adjusted gross income; 1040 line 37) are deductible. Example: If your AGI is $50,000, that's $3750. If your medical expenses are $4000, you can only deduct $250 – and only if all your itemized expenses together are greater than the standard deduction. The floor for job expenses and some miscellaneous deductions is 2% of AGI.

3) Your tax benefit for a deduction is just a fraction of the amount you spent. If you're in the 15% tax bracket, a $100 deduction will save you $15 in taxes. If you're in the 25% tax bracket, it would save you $25. If you owe no tax, you'll get no benefit from the deduction.

4) If you owe no tax anyway, you'll get no benefit from deductions. Consider a single mom with three dependent children who was laid off in the middle of the year. After subtracting her standard deduction ($8,500 for head of household) and exemptions for her and her children (4 x $3700), any taxable income that's left will be erased by credits such as the earned income tax credit, credit for child care and the child tax credit. Result? Not tax benefit from any of the deductions.

In addition to the itemized deductions declared on Schedule A, there are additional categories that are taken "above the line," meaning you subtract them right on your 1040 (lines 23 to 35) before calculating your Adjusted Gross Income. This makes "above the line" deductions particularly valuable: you don't have to itemize in order to claim them, and they may help you qualify for your other tax deductions or benefits that are based on income. You'll get a tax benefit from these, unless your income is low enough that you owe no tax without them.

Some of the more common above-the-line deductions are:

  • Deductible IRA contributions
  • Health savings account contributions
  • Tuition and fees for post-secondary education
  • Student loan interest
  • Alimony payments

Before you decide to make major financial decisions between now and December 31 to increase your deductions, do some quick math. Or take a look at last year's tax return. Evaluate whether you'll benefit from those actions, and look for smarter alternatives.

  • If you can't deduct a contribution to a traditional IRA, contribute to a Roth IRA instead.
  • If you won't be able to deduct a charitable contribution and you're over 70½, you could have your distribution from IRA sent directly from the plan to a charitable organization – a Qualified Charitable Distribution – and avoid having the distribution taxed as income.
  • If your itemized deductions are usually very close to the amount of your standard deduction, think about "clumping" your deductions every other year. For example, delay your year-end charitable contributions for 2011 until January of 2012, make your regular 2012 contributions, and increase the chance that you'll be able to benefit from itemizing for 2012.

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