As we enter the heart of tax season, there's a concept that's lost on many people -- that not all deductions have the same value. That's because it matters whether they're "above the line" or "below the line."
The line, in a sense, is your adjusted gross income (AGI), on which your taxes are largely calculated. Above-the-line deductions are taken before you arrive at your final AGI; they appear either as subtractions from income items or as explicit deductions on your 1040 and help you actually arrive at your AGI. Below-the-line deductions are taken after you have determined your AGI and can reduce your taxable income further.
To clarify this distinction, here are some examples:
- Above-the-line deductions: Schedule C or F business deductions, rental deductions, and adjustments to AGI such as contributions to a traditional IRA, alimony, stock losses up to $3,000, moving expenses, or student loan interest paid.
- Below-the-line deductions: Itemized deductions such as charitable donations and medical, tax, interest, and miscellaneous expenses.
Now think of the whole process this way: You start with your gross income and subtract your above-the-line deductions, arriving at your AGI. Then you subtract your below-the-line deductions or the standard deduction (whichever is greater) to arrive at your taxable income.
Here's how our tax expert, Roy Lewis, has explained the difference in the deductions: "Above-the-line deductions are generally more beneficial than below-the-line deductions because they not only reduce your taxable income, but also reduce your AGI, which may favorably affect many of your subsequent computations. Below-the-line deductions simply reduce your taxable income."
So in a nutshell, above-the-line deductions will always lower your taxes, but below-the-line ones may not, if they don't exceed your standard deduction amount. Those who are self-employed will have more above-the-line deductions, but even those who aren't might benefit by keeping better records of their expenses. If you have enough deductions to itemize them instead of taking the standard deduction, you can cut your taxes.
Also, as an investor, be sure to make the most of losses on stocks. Although it's too late to sell and take losses on your 2006 return, it's never too early to think about your 2007 taxes. For instance, if you lost money on poor-performing stocks like Sirius Satellite (Nasdaq: SIRI ) , or on Marvell Technology (Nasdaq: MRVL ) , you can at least ease the pain a little by reducing your taxes.
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Longtime Fool contributor Selena Maranjian does not own shares of any companies mentioned in this article.