UPDATE: On March 21, 2020, The Treasury Department and Internal Revenue Service announced that the federal income tax filing due date is automatically extended from April 15, 2020, to July 15, 2020.
The first step in completing your annual income tax filing is to sum up your gross income. You do not, however, pay tax on your gross income. You pay tax on your taxable income. In this post, we talk about some of the things you can subtract from your gross income to whittle it down to your taxable income.
Deductions come in two types — those deducted to determine your adjusted gross income (AGI) and those deducted from AGI to determine your taxable income. While your tax liability is not calculated from your AGI, it is an immensely important number that can affect your bottom-line tax burden (and many other things about you). For instance, if your AGI is above certain thresholds, you will lose the ability to take certain deductions or claim certain tax credits.
DEDUCTIONS FOR AGI
Deductions taken to determine AGI, so called “above-the-line” deductions, often relate to expenses incurred to run a business (e.g., self-employed taxpayers can deduct certain ordinary and necessary business expenses and a portion of their self-employment taxes). Deductions are also allowed to incentivize certain taxpayer behavior. Indeed, a few of these deductions are accounted for in your W-2 (e.g., contributions to your 401(k), 403(b) and 457 plans; contributions to your health savings account and medical spending account).
For years Congress allowed alimony payments to be deducted for AGI. The other side of this arrangement was that alimony recipients had to report the payments as gross income. The current rule is that alimony payments are only deductible if they are the result of a divorce or separation agreement finalized by the end of 2018.
Another popular for AGI deduction relates to student loans. The tax code allows a deduction of up to $2,500 per return for interest payments made on qualified educational loans that were used to pay for the taxpayer’s (or his or her spouse’s or dependent’s) educational expenses (e.g., tuition, fees, room, board, etc.). This deduction may be reduced or eliminated if the taxpayer’s income is too high.
DEDUCTIONS FROM AGI
Once AGI is determined, taxpayers have a choice of taking either a standard deduction or itemizing their deductions in order to calculate their taxable income.
The Standard Deduction
The standard deduction is largely based on your filing status. Table 1 below shows the standard deduction allowances for 2019.
|Filing Status||Standard Deduction
|Single or Married filing separately (MFS)||$12,200
|Married filing jointly (MFJ) or Qualifying widow(er) ||$24,400
|Head of Household||$18,350
For taxpayers (or spouses) who are blind and/or 65 or older, additional amounts are added on top of these deductions.
There are some standard deduction limits for specific situations, and more information may be found in Publication 501 for 2019 Returns (PDF).
You may choose to itemize deductions rather than taking the standard deduction if it reduces your taxable income by a greater amount. There are many expenditures that may qualify as itemized deductions, and, like with most things in tax, there are limitations and exclusions involved. Below, we offer a brief summary of a few of the more common items.
- Medical Expenses – Taxpayers who have incurred a high amount of medical expenses may be able to deduct a portion of those expenses. Notable expenses in this area are payments for prescription medication, doctors’ visits, transportation for medical purposes and health insurance premiums. The deductible portion of these expenses is reduced by any amounts a taxpayer has had reimbursed or has already deducted for AGI (common with premiums). The deductible portion is further reduced by 10% of the taxpayer’s AGI.
- Taxes – Taxpayers may deduct state, local and foreign income taxes paid during the year. If it is more beneficial, a taxpayer may choose to deduct sales tax instead of income taxes. State and local real property taxes may also be deducted, as well as state and local personal property taxes (if the tax is based on the value of the property). Most taxpayers may deduct up to $10,000 of tax payments per year ($5,000 for MFS).
- Home Mortgage Interest – Taxpayers may deduct interest paid on their mortgage loans. For mortgage loans taken out prior to December 16, 2017, a taxpayer can deduct the interest paid on up to $1M of debt ($500,000 for MFS). For home loans secured on or after this date, the limit is reduced to $750,000 ($375,000 for MFS).
- Charitable Contributions – In general, taxpayers can deduct the value of cash and property donations they make to qualified charities (refer to the Internal Revenue Service’s Tax Exempt Organization Search webpage for organizations that qualify). Whether a taxpayer writes a check to their local church or drops off clothes at a Goodwill center, they will be able to claim the amount of the donation as a charitable contribution deduction. The total amount of this deduction may be limited based on the taxpayer’s AGI, the type of property they donate and the type of organization receiving the donation.
Qualified Business Income Deduction
Another deduction that may be made from AGI is a relatively new addition to the tax code. In 2018, Congress introduced the qualified business income (QBI) deduction. The technicalities surrounding this deduction and who may claim it are vast, but we believe it is helpful to at least put it on your radar in this blog. The QBI deduction allows certain types of businesses—like sole-proprietorships, S-corporations and partnerships—engaged in certain types of activities to deduct up to 20% of their qualified business income.
The overall take home from this post is that the amount of income subject to tax is often far lower than the amount of reported gross income. Even if a taxpayer has zero deductible expenditures, this is still true, as they may claim the standard deduction. The next installment of our series will specifically focus on the tax implications of retirement savings and home ownership.
Dr. James A. Weisel and Dr. Benjamin Akins are faculty members in the Georgia Gwinnett College School of Business. The content of this blog should not serve as a substitute for legal advice from an attorney or accountant familiar with the facts and circumstances of your specific situation. If legal or accounting assistance is needed, we recommend that you seek the services of a qualified professional.