Yes, I know. Tax season is far, far past us (cue angelic chorus from above). Those tight deadlines and stacks of financial documents are all nicely tucked away in our mental or physical files--or completely forgotten and shredded.
So why discuss taxes in the Summer? Filing taxes each year is one thing, but doing a little tax planning for your family is not only essential, but it’s wise to do so well before year’s end.
In that light I’d like to discuss tax deductions, but with a perspective that’s crucial to understand which I don’t hear discussed very often. And while I’m not a tax professional, I feel that understanding the nature of deductions can make one of the most significant financial impacts on your tax situation each year.
“Thinking is one thing no one has ever been able to tax.”
Not all deductions are created equal
For a long time I believed what most people do: tax deductions are great, but they’re of the same “make” and can be lumped into one category. There are deductions for retirement contributions, charitable giving, mortgage interest, HSA contributions and so on, but they all pretty much work the same way on my tax form.
Nothing could be further from the truth.
Not only are there actually two broad categories of tax deductions, but they work very differently from each other. I’ll group these deductions into two categories: Above-the-Line deductions and Below-the-Line deductions.
Tax Deductions...and Finding Your Taxable Income
If you look at a copy of IRS Form 1040 (the standard form for submitting your taxes), you’ll see the Income section with a variety of income sources listed. Add these up and you have your Total Income.
Click this and other 1040 images to see in a larger view.
Most of us know that income tax isn’t paid on Total Income. Instead, your Total Income is “adjusted” with certain deductions to get to your Adjusted Gross Income (AGI). These deductions are your Above-the-Line deductions, meaning they’re “above” line 37 showing your AGI, which is a key number for determining other possible deductions and how much you’ll actually pay in taxes each year.
However, your taxes are NOT paid on your AGI, either.
Continuing on to line 40, we see the section to claim your itemized deductions or the standard deduction. These itemized deductions are your “Below-the-Line” deductions since they come after you’ve determined your AGI on line 37.
Finally, line 43 shows the amount of income on which you’ll actually pay taxes--your Taxable Income.
To lay this out as a simpler formula would look like this:
Total Income
- Above-the-Line Deductions
= Adjusted Gross Income
- Below-the-Line Deductions or the Standard Deduction
= Taxable Income
Whew! Count on the IRS to make things a bit more complicated!
So what difference does all this extra math make? Ultimately both deduction types are taken from your Total Income, so what makes one deduction type superior to the other? It all goes back to your AGI number.
How Above-the-Line Deductions Make a Bigger Financial Impact
First, notice where the Standard Deduction comes into the formula above. Since the Standard Deduction is “below” the AGI it can be claimed whether you have Above-the-Line deductions or not. Your Below-the-Line deductions (itemized deductions) can only be claimed if you don’t claim the standard deduction. This is not the case for Above-the-Line deductions.
Does it make more sense to itemize your deductions? Great, you’re free to do so but you can still claim all the Above-the-Line deductions you qualify for. Is the standard deduction a better move for your family? Cool, you can still claim your Above-the-Line deductions.
Second, it’s important to remember that some tax benefits are reduced or eliminated if AGI exceeds a certain amount. This a particular area of concern for high income earners. Things like education and adoption credits may be eliminated if your AGI is too high, or certain surtaxes may be charged, such as increased Medicare premiums. Do you think everyone who owns their home qualifies for a property tax deduction (below-the-line)? Not if your AGI is too high.
Taking Above-the-Line deductions to lower your AGI can potentially earn you tax credits or qualify your for Below-the-Line deductions that you might otherwise be ineligible for.
Examples of Above-the-Line Deductions
So what are the most common and most overlooked Above-the-Line deductions? Let’s take one final look at IRS Form 1040:
I’m sure a few of these have jumped out at you. Contributions to an IRA or other qualified plan, like your company or Solo 401(k) plan, are Above-the-Line deductions. So are Health Savings Account contributions. Interest paid on student loans? That’s also Above-the-Line.
Others are less common. I’m not sure what act of Congress (or degree of arm twisting) it took to get moving expenses listed here, but there they are. There are several deductions for the self-employed as well, including self-employed retirement plans.
It’s important to keep in mind that each of these deductions have their own limits, such as how much you can contribute to your HSA or 401(k) plan. Still, the benefit of these deductions to reduce AGI cannot be understated and well may be the most important tax planning strategy for any family.
I hope this look at tax deductions has been helpful for you. Remember a few key takeaways:
- Not all tax deductions are created equal
- Above-the-Line deductions can have a more significant financial impact than Below-the-Line deductions
- As you continue through 2017, consider ways to take greater advantage of Above-the-Line deductions, such as contributing to an HSA or IRA (if you qualify).
Above-the-Line deductions can decrease your AGI and drastically improve your family’s financial picture through decreased taxes, increased tax credits, or perhaps a combination of the two.
Who knows, perhaps doing so will make next year’s tax season a more pleasant experience as well! (Hey, don't laugh!)