The amount of federal income tax you owe is figured by taking your gross income and subtracting from it certain allowable adjustments, deductions, and exemptions. A deduction may be defined as an expense used to offset income. Taxpayers may subtract certain deductions, or adjustments, in calculating adjusted gross income (AGI). Taxpayers may then subtract the greater of either their statutory standard deduction or the total of their itemized deductions. An exemption, on the other hand, is a special type of deduction granted to individuals to relieve them from taxation. In general, taxpayers are entitled to exemptions for themselves and their dependents. (Personal and dependency exemptions have been suspended for 2018 to 2025.) Knowledge of your available deductions and exemptions is an important part of your tax planning. If your income level is above a specified amount, the tax benefits of some personal and dependent exemptions are phased out. (Phaseout of these exemptions are also suspended for 2018 to 2025.) In addition, certain deductions are only available to you if your expenses exceed a particular percentage of your AGI.
What's the difference between above-the-line and below-the-line deductions?
AGI is an important line of demarcation on Form 1040. Deductions that help you arrive at your AGI are known as "above-the-line" deductions, and deductions that are subtracted from your AGI (such as the standard deduction or itemized deductions) are known as "below-the-line" deductions. An above-the-line deduction is an adjustment to your gross income. It reduces your AGI and can be claimed regardless of whether you itemize deductions on your income tax return. Adjustments to income include the following:
- IRA deduction for you and for your spouse
- Student loan interest deduction
- Deduction for qualified higher education expenses (for tax years 2004 through 2020)
- Archer MSA or health savings account (HSA) deduction
- Deduction for moving expenses (generally suspended for 2018 to 2025)
- Deduction for one-half of your self-employment tax
- Self-employed health insurance deduction
- Deduction for Keogh retirement plan and self-employed SEP or SIMPLE plan
- Penalty on early withdrawal of savings
- Deduction for alimony paid (pre-2019 divorces, unless divorce agreement provides otherwise)
(See the instructions to Form 1040 for additional adjustments that may apply.)
Tip: There is an above-the-line deduction for up to $250 (in 2021) annually for classroom expenses paid for or incurred by an eligible educator for books, supplies, computer and other equipment, and other supplementary materials. Starting in 2016, the deduction is also available for expenses for participation in professional development courses and the $250 amount is indexed for inflation. Eligible educators include kindergarten through grade 12 teachers, instructors, counselors, and principals who are in school for at least 900 hours during the school year. Amounts over the $250 limit may still be taken as a miscellaneous itemized deduction, subject to the 2 percent floor. (The deduction for miscellaneous itemized expenses subject to the 2 percent floor is suspended for 2018 to 2025.)
Tip: The American Jobs Creation Act of 2004 created an above-the-line deduction for attorney's fees and costs paid by, or on behalf of, a taxpayer in connection with any action involving a claim of unlawful discrimination, certain claims against the federal government, or a private cause of action under the Medicare Secondary Payer statute. The amount that can be deducted cannot exceed the amount includable in gross income for the taxable year on account of a judgment or settlement resulting from the claim. This deduction is effective for fees and costs incurred after October 22, 2004.
Should you take the standard deduction or itemize your deductions?
From your AGI, you may subtract the greater of either the statutory standard deduction or the total of your itemized deductions. Obviously, you should choose whichever method provides you with the greatest tax benefit. The standard deduction varies according to your filing status and is indexed for inflation yearly. Itemized deductions are deductions from AGI and are allowed for certain expenditures that are primarily personal in nature. If you choose to itemize deductions, you must complete Schedule A of your federal income tax return. There are some limitations regarding who can use the standard deduction and who can itemize.
Which expenditures qualify as itemized deductions?
Those expenditures that qualify for itemizing include the following:
Casualty and theft losses
A casualty is the damage, destruction, or loss of property resulting from an identifiable event that is sudden, unexpected, or unusual. A deduction is allowed for losses of business property, investment property, or nonbusiness property caused by fire, storm, or other casualty, including theft. If you recover any amount of the loss by insurance, you must reduce your deduction accordingly. For 2018 to 2025, an individual can deduct personal casualty losses only to the extent attributable to a federally declared disaster.
You are allowed to take a tax deduction for contributions you make to qualified charitable organizations, provided you satisfy detailed rules that often require you to substantiate your gifts.
Investment interest and other interest
Investment interest is interest paid on indebtedness regarding property held for investment purposes. There are specified limits on the deduction of investment interest by individuals.
Medical and dental expenses
Medical expenses paid by the taxpayer for diagnosis, cure, relief, treatment, or prevention (for the benefit of the taxpayer, spouse, and dependents) are allowed as an itemized deduction to the extent the expenses are not reimbursed. This deduction is limited to the amount by which such unreimbursed expenses exceed 7.5 percent of the taxpayer's AGI.
Generally, mortgage interest is any interest you pay on a loan secured by your home. Most home mortgage interest is deductible in the year paid, subject to certain limitations. However, there may be limits on your ability to deduct the full amount of "points" in the year paid. (Points are certain charges paid by a borrower in connection with a loan; essentially, they represent interest paid in advance.) For 2018 to 2025, interest is not deductible unless the debt secured by your home is incurred in acquiring, constructing, or substantially improving your home.
State and local taxes
You can deduct state and local income taxes (on Schedule A) in the year paid (if you itemize). Likewise, real estate taxes and certain personal property taxes are deductible in the year they are paid. For 2018 to 2025, the deduction for state and local taxes is limited to $10,000 ($5,000 for married filing separately) in total.
Tip: A taxpayer can elect to take as an itemized deduction state and local general sales taxes in lieu of the itemized deduction provided for state and local income taxes. This deduction is available for tax years beginning after December 31, 2003.
Miscellaneous itemized deductions
The deduction for miscellaneous itemized expenses subject to the 2 percent floor is suspended for 2018 to 2025.
Numerous other possible deductions exist for itemization. Certain miscellaneous itemized deductions are deductible only to the extent that the total of all these deductions exceeds 2 percent of your AGI. Common deductions subject to this 2 percent floor include hobby expenses, employee business expenses, and tax-preparation fees.
Phaseout of itemized deductions
The phaseout of itemized deductions is suspended for 2018 to 2025.
Prior to 2018, taxpayers with higher incomes may not have been able to deduct all of their itemized deductions. You were subject to a limit on certain itemized deductions if your adjusted gross income (AGI) exceeded $261,500 (in 2017) for single taxpayers, $313,800 (in 2017) for married taxpayers filing jointly, $156,900 (in 2017) for married taxpayers filing separately, and $287,650 (in 2017) for heads of households. More specifically, the amount of your itemized deductions was reduced by 3 percent of the excess of your AGI over the above threshold for your filing status.
This overall limitation was imposed after any other limitations were applied (such as the miscellaneous 2 percent floor). However, medical expenses, casualty and theft, gambling losses, and investment interest expenses were not subject to this limitation, and in no case could the reduction be more than 80 percent of your otherwise allowable deductions.
What are the personal and dependency exemptions?
The personal and dependency exemptions have been suspended for 2018 to 2025.
Personal and dependent exemptions reduce your taxable income. The exemption amount is indexed annually for inflation (the figure is $4,050 for 2017). Generally speaking, you are entitled to one exemption for yourself, one exemption for your spouse (if you are filing a joint return), and one exemption for each person whom you can claim as a dependent. However, a number of limitations and rules apply.
Phaseout of exemptions
The tax benefits of the personal and dependent exemptions are phased out for taxpayers whose adjusted gross income exceeds specific amounts. The phaseout is accomplished by reducing the exemption amount allowed by 2 percent for each $2,500 (or fraction thereof) of AGI in excess of certain levels (for married filing separately, the $2,500 amount is reduced to $1,250). Personal and dependent exemptions are subject to phaseout if your AGI exceeds $261,500 (in 2017) for single taxpayers, $313,800 (in 2017) for married taxpayers filing jointly, $156,900 (in 2017) for married taxpayers filing separately, and $287,650 (in 2017) for heads of households. In other words, if your AGI exceeds the above amount for your filing status, your exemption amount is reduced by 2 percent for each $2,500 (or fraction thereof) above the limit (for married filing separately, the $2,500 amount is reduced to $1,250).