Below the Line Tax Deductions

The following is provided courtesy of Marotta Asset Management and offers their thoughts on below the line tax deductions (FYI, here's a link to their piece on above the line tax deductions):

Not all deductions are created equal. Some deductions are more valuable than others. What matters is whether or not the deduction is "above the line" or "below the line". The line in this case is your adjusted gross income (AGI).

Above the line deductions are subtracted from your gross income in order to compute your AGI. Therefore, above the line deductions reduce your AGI which also reduces your taxable income. Reducing your AGI can lower many subsequent calculations which will lower other taxes you may have to pay. As a result, above the line deductions are more advantageous than those taken below the line. They are like Dorothy's ruby slippers, once you have them on the Wicked Witch of Taxland can't touch you.

Below the line deductions are more uncertain. Like many items in the tax code the correct answer to "Will they reduce my taxes?" is: "It depends." They are like Dorothy's first encounter with the Wizard. He promises to grant her requests if she would only bring him the witch's broomstick and she never thinks to challenge the man behind the curtain.

AGI minus your personal exemptions and deductions equals your taxable income. You can claim a personal exemption for you, your spouse, and your dependents. In 2007, you can reduce your AGI by $3,400 for each exemption you claim. These exemptions are subject to phase outs above $234,600 for joint filers ($156,400 for singles).

Below the line deductions are subtracted from your AGI to compute your taxable income. You can either itemize your deductions or you can take a standard deduction, whichever is greater. In order to gain from itemizing, your itemized deductions must exceed your standard deduction. Nearly two out of three taxpayers do not gain and choose to take the standard deduction instead.

Your standard deduction is a fixed dollar amount based on your filing status plus some specific adjustments. For 2007, your standard deductions is $5,350 if you are single, $7,850 if you are the head of household, or $10,700 if you are married filing jointly. You can take an additional standard deduction of up to $1,050 if you are age 65 or older.

Home ownership is the most common way to boost your deductions above the standard deduction. The IRS allows home owners to deduct their interest payments each year. If your home mortgage is at 6% and your payments are mostly interest, then most of your mortgage is tax deductible. If your marginal tax rate is near one third, the government is paying 2% of your interest, and you are only paying 4% of your interest. For most middle class families that results in a huge tax savings.

The benefits of a mortgage are greater when the majority of your payment is interest, not principle. There is no tax deduction for payment of principle. Therefore, you want as many years of interest payments as possible. As a result, 30-year mortgages have much greater tax savings than 15-year mortgages.

When it comes to maximizing your deductions, home owners can also deduct real estate taxes and points paid down on the loan. The cost of the points can be deducted over the price of the loan. So, If you paid $3,600 in points for a 30 year mortgage you can write off $10 a month, or $120 each year. If 10 years into the loan you refinance again, all the remaining points that haven't yet been deducted are deductible in the year you refinance anew. In our example that would be $2,400.

If home ownership alone doesn't make itemizing worthwhile, your state and local taxes (including personal property taxes) along with any charitable deductions may push you over the top. Alternately, if you have high medical expenses which exceed 7.5% of your AGI, you can deduct them as well.

Once you have ensured that your itemized deductions are over your standard deduction there are several smaller deductions that can increase your tax savings.

Miscellaneous itemized expenses can be deducted only when their total exceeds 2% of your AGI. For most people, their deductions are too low or their AGI is too high. But, if your income drops for a year, or you retire, you may qualify.

Deducting miscellaneous expenses is difficult unless you keep good records throughout the year. Qualifying expenses may include work related expenses, legal or accounting fees related to tax preparation, investment advisory fees, estate planning and investment expenses including your safety deposit box, professional dues, and newspaper subscriptions.

Overall, keeping good records is vital to determining whether you can itemize your deductions come tax time. Itemizing your deductions may provide you with some additional tax savings. With an overflowing bucket of deductions and exemptions, your tax burden will soon be melting.

Comments

[Phil]

Of course tax credits are the most valuable of all! Deductions taken directly off your tax bill are worth 3x above the line deductions. Also, at what point does the AMT wipe all this out all of your above the line deductions?

[beastlike]

Yah, when do we have to start worrying about AMT? $110k? $120k?

[Kevin]

It really depends on your deductions. Even someone with lower income can get hit with AMT if they are deducting a disproportionate amount on Schedule A. The biggest one I see is someone that has a spike in income (capital gains, etc) that leads to a big state income tax bill one year so they pay it in the following year when their income goes back down, so their state income taxes are out of whack with the current earnings.

[beastlike]

Kevin - So if your wife and you basically earn 110k from your jobs and maybe up to only 5k in interest on CD's/savings/etc. is there a decent chance you won't get hit with AMT?

With that being said, what salary is safe to say you won't get hit with AMT if you don't have large capital gains to worry about?

[plankton]

We make 175K joint and have what I would consider fairly vanilla deductions (2 kids, medium-sized mortgage). So far, we have not been hit by AMT, but I freak out about it every April...

[Kevin]

beastlike - i just used capital gains as an example. AMT is caused by many things, but the most common items are extremely high deductions for state income taxes, mortgage interest, medical or miscellaneous deductions.

You should be OK with that level of income assuming your itemized deductions aren't ridiculously high. Your tax preparer should be able to give you an idea of how close you are. The form really isn't hard to fill out if they are using tax software, since everything that goes over to it is usually input somewhere already. At my firm, we always print out the AMT form to make sure there are no surprises.

There are also other kinds of gifts you can make to reduce taxes for long- term estate planning. First, you can give up to 12,000 per donor per recipient to family members and others each year without triggering gift taxes. You can also give to your children’ s or grandchildren’ s education through 529 savings plans. You can gift 12,000 a year to a 529 plan tax- free— or better yet, take advantage of a law that allows you to give a single contribution, covering five years, to a 529 plan. That means you can...