Standard vs. Itemized Deductions
Standard vs. Itemized Deductions
I often get questions from clients wondering if they should take the standard deduction on their taxes or use itemized deductions. My response is usually, “It depends. Use whichever method that lowers your taxes the most, but also what makes the most sense.”
First things first....
What is a deduction? Basically, “a deduction” is a dollar amount that reduces the amount of income that you are taxed on. For example, if your income is $60,000, and your federal tax bracket is 20%, then you owe the federal government $12,000 in taxes for the year. However, if you can claim a deduction of $8,000 on your tax return, then your taxable income is now $52,000 ($60,000 minus $8,000). You would only owe $10,400 in taxes instead of $12,000. Your deductions resulted in a tax savings of $1,600!
Next....
What is the standard deduction?
Everyone is entitled to a standard deduction to reduce your taxable income. The dollar amount varies depending on your tax filing status. For the 2012 tax year, the standard deduction is:
$ 5,950 for single filers or married people filing separately,
$11,900 for married people filing jointly, or
$ 8,700 for head of household filers
Note: You can also have a slightly higher standard deduction if you are blind, age 65 or older, or both.
Pretty straightforward stuff.
What is an itemized deduction?
The use of itemized deductions is another way of calculating one’s deduction. Various items qualify as itemized deduction including (but not limited to):
1)Medical expenses
2)State income taxes
3)Real estate taxes
4)Personal property taxes
5)Mortgage interest
6)Charitable contributions
7)Investment interest
8)Unreimbursed employee expenses
9)Tax preparation fees
(See IRS Form 1040 Schedule A and the form instructions for a complete listing of the itemized deductions).
One question that I always get is “My friend told me that “X” expenses count as an itemized deduction. Why are you not claiming it for me?” Often the answer to this question is because of the limitations that are set by the IRS. Many of the itemized deductions listed above are limited.
For example: In order to claim medical expenses as an itemized deduction, per the IRS rules, only the amount that EXCEEDS 7.5 percent of your AGI (adjusted gross income) can be claimed as an itemized deduction.
So if your adjusted gross income is $100,000, 7.5 percent of $100,000 is $7,500. So, you must spend over $7,500 in order to claim the itemized deduction. Furthermore, it is the amount that is ABOVE 7.5% (or in this case $7,500) that can be claimed. So, if your medical expenses for the year was $8,000, you could only claim $500 as a medical expense itemized deduction.
In general, if your allowable itemized deductions are greater than the standard deduction for your filing status, then it makes sense to claim itemized deductions on your tax return, as it should result in a lower tax liability. However, if your allowable itemized deductions are less than your standard deduction, then you should claim the standard deduction to minimize your tax liability.
Record Keeping:
When you claim the standard deduction, you do not need to worry much about keeping records to substantiate that amount - since it’s preset by the IRS based on your filing status. However, if you choose to claim itemized deductions, you will need to maintain all the records supporting the deduction amount (i.e. statements, contribution receipts, property tax statements, etc). All of your tax documents and back-up records should be kept for at least 3 years, but I recommend keeping them for at least 7 years.
In addition, I would suggest that at the beginning of each year, you take an inventory of the future expenses that you expect to incur, to see whether you might be using itemized deductions, as opposed to the standard deduction. If so, start saving your records. Often times, I have clients who, after meeting with me, realize they can claim many more deductions, but they have not kept track of their accounting records (receipts, statements). It’s often very painful at that point to try and find those records. So please start planning early!
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