"In this world nothing can be said to be certain, except death and taxes."
-- Ben Franklin
We only die once, but we get to deal with taxes every single year. And while taxes are a necessary evil that pay for everything from infrastructure to defense to a safety net for the aged, nobody should pay a penny more than the law calls for.
Unfortunately, the federal tax code is one of the most complex there is, but that's largely a product of many changes over the years that have in a large part created ways for people to reduce their taxes, through itemized deductions.
What are itemized deductions? Do you qualify for them? Should you use them? Let's take a closer look.
What is a deduction?
There are two categories that people often confuse: credits and deductions.
A tax deduction doesn't actually reduce your taxes owed directly. Instead, it reduces your taxable income. By reducing the amount of your income that can be taxed, the result is lower taxes. Common deductions include:
- Contributions to qualified retirement savings accounts.
- Housing costs such as mortgage interest.
- Charitable donations.
A tax credit, on the other hand, is just what the name describes: a credit for taxes paid or owed that directly reduces taxes. Common examples:
- Disaster relief (such as for flood or hurricane victims).
- Renewable-energy system investment, such as a solar-panel system.
- Earned Income and Saver's Credits.
Tax credits are typically designed to do one of a few things: create financial incentive for people to invest in a new technology that offers some significant benefit for society or the American economy (such as solar power), provide financial relief for victims of a natural disaster, or offer financial support for those at the lowest economic levels.
Tax deductions can also create financial incentives such as the charitable giving deduction, and support for those with lower incomes like the Earned Income Credit, but many of the deductions are in place to reduce some typical household expenses from taxable income.
According to the Internal Revenue Service, the standard deduction is "a dollar amount that reduces the amount of income on which you are taxed." The IRS continues: "In general, the standard deduction is adjusted each year for inflation and varies according to your filing status, whether you are 65 or older and/or blind, and whether another taxpayer can claim you as a dependent."
In general, the standard deduction is available to most tax filers whom someone else can't claim as a dependent, or whose spouse isn't filing separately and itemizing deductions. For 2015, the standard deduction is $6,300 for single filers, $12,600 for joint filers, and $9,250 for head-of-household filers. The standard deduction would be for situations in which your eligible deductible expenses fall below the standard deduction.
There's more, as specific situations could increase or lower the amount of the standard deduction you're able to claim, so be sure to make sure your situation applies. For more information on the standard deduction and whether it's right for you, check out Dan Caplinger's article here.
Popular itemized deductions
Here are some of the most popular itemized tax deductions people take:
- Mortgage interest: Considering how front-loaded home mortgages are, it's common for homeowners to itemize, and reduce their taxable income by mortgage interest paid. This alone can exceed the amount of the standard deduction for the first few years of a mortgage.
- Charitable donations: This can be both money and the fair market value of goods donated to qualified charities.
- Local and state income and real estate taxes paid: That's right -- taxes paid to your local or state government may qualify as a deduction.
- Qualified health and dental expenses: If you pay more than a certain portion of your income for out-of-pocket medical and dental expenses, you may be able to get a deduction for those expenses.
- Certain work-related expenses: You can claim certain expenses that your employer doesn't fully reimburse, such as mileage, parking and tolls, travel-related costs including meals and lodging while away from home overnight, entertaining clients, or a home office (but only if it's dedicated 100% to work).
- Education-related expenses: This can include student-loan interest for past education, but also educational expenses related to your current occupation or profession.
- Investment-related items: If your employer doesn't offer a retirement account, you can make contributions to an individual retirement arrangement each year and deduct those contributions from your taxable income for that year. In 2015, those under 50 can contribute up to $5,500, while those 50 and over can contribute up to $6,500.
- Investment losses: If you sold a qualified investment at a loss during a specific year, you can claim your loss as a deduction. But first, you have to subtract the loss against any taxable capital gains you earned that year, which would be considered income. The total in net losses (after factoring out gains) that you can take as a deduction is currently $3,000 for 2015.
These cover some of the most popular deductions, but there are even more that may apply to your situation. Check out the IRS website for more information on deductions.
Should you use itemized deductions? Probably so.
If your qualifying expenses exceed the standard deduction that you're eligible for, then you should absolutely use itemized deductions. It does add more complexity, requiring documentation to support each of the deductions and a more complicated tax return (much more so, in some cases), but it puts more money in your pocket.
So if you travel for work, donate goods, or entertain clients, it's important that you keep a detailed financial record of these expenses. Typically, the best thing to do is keep every receipt you can. The bottom line is, if you ever get audited, you want to be able to document the validity of your claims. Most importantly, don't not claim a valid deduction just because someone says you might get audited. If you have the documentation to prove it was a valid deduction, you should have nothing to worry about. Besides, if you work with a reputable tax preparer or accountant, that person will make sure you're prepared to deal with an audit if necessary. And did you know that tax-preparation costs are tax-deductible? Yep.
The bottom line: The U.S. tax code can be confusing, but it's the law. If you qualify for a specific deduction, you're well within your legal rights to take advantage of it. Frankly, not doing so is leaving your own money on the table.