Taxpayers are always on the lookout for good ways to deduct income on their tax returns. Whether it's buying a Hummer for one's business to exploit a special expense rule, or donating an old vehicle to charity, there's often a tax angle to consider in making financial decisions.
However, at some point, you simply run out of deductions. Once you've reached your limit, you need to figure out how to make the best of the deductions you already have. For many taxpayers, actively managing your tax deductions by timing certain expenses can save you money on your taxes. Active tax management doesn't mean hiring H&R Block
Wasting the standard deduction
When it comes to taking tax deductions, most taxpayers have two choices: They can either keep records of their deductible expenses and itemize their deductions on Schedule A, or they can simply take the standard deduction. For married couples who are under age 65 and not legally blind, the standard deduction for 2006 is $10,300. If you're certain that your deductible expenses this year will be less than $10,300, you don't have to do any extra work tracking your deductions; you can just take the standard deduction.
Consider a couple that tends to have somewhere around $10,000 in deductible expenses each year. In a way, this couple is wasting their standard deduction. In years in which they have deductible expenses that are slightly less than the standard deduction, then the standard deduction is only worth an extra few hundred dollars. When their expenses exceed the standard deduction, they have to do all the work involved in itemizing their deductions, but again, they only get a few extra hundred dollars more for their effort.
Compare this situation to one in which another couple manages the timing of their expense payments, so that they have higher expenses in some years and lower expenses in others. For example, if this couple manages to pay their expenses in a way that gives them deductions of $15,000 in even-numbered years and $5,000 in odd-numbered years, then they will take advantage of the standard deduction to a greater extent. During the high-expense years, itemizing deductions will save them a significant amount over taking the standard deduction. On the other hand, during the low-expense years, using the standard deduction will earn them thousands of dollars in extra deductions over itemizing. Even though the two couples pay close to the same amount in expenses, the timing of paying those expenses allows the second couple to deduct almost $5,000 more over a two-year span. Depending on your tax bracket, those extra deductions can put more than $1,000 back into your pocket when you get your income tax refund.
There are other similar situations in which timing deductible expenses can work to your advantage. If you have expenses that never quite make it to the standard deduction amount, paying for two years of expenses at once can help push you over the top. On the other hand, if your expenses always slightly exceed the standard deduction, bunching your expenses into a single year can let you benefit from the standard deduction during low-expense years.
What expenses work best
According to IRS statistics for the 2004 tax year, the types of deductions that make up the largest portion of overall itemized deductions include home mortgage interest, state and local income and sales tax, real estate tax, and charitable contributions. Of these four categories, home mortgage interest is probably the expense over which most people have the least control. On a fixed mortgage, the amount of interest you're paying is determined in advance on your amortization schedule. Even for adjustable-rate mortgages, you can't really predict whether changes in interest rates will increase or decrease your mortgage interest from one year to the next.
The other major deductible expenses, however, give you some flexibility in timing your payments. Many states and counties give property owners the option of paying their real estate taxes in installments that sometimes span over two calendar years. In such cases, by paying one year's taxes in installments and then paying the next year's taxes in full, you can switch back and forth between high-expense and low-expense tax years. Similarly, with income taxes, you can choose to pay projected taxes early, rather than waiting until April 15 of the following year. You have complete flexibility over charitable contributions; it's just as easy to write a check on Jan. 2 as on Dec. 29.
Consider your tax bracket
The basic strategy for doubling up on expenses assumes that your income and expenses stay relatively constant from year to year. If, however, your income is subject to dramatic fluctuations, you may end up paying different rates of tax, depending on how good a year you had. Under these circumstances, if you have some advance notice that your income will be high during a particular year, you can maximize your tax savings by concentrating expenses into that year. In the simplest terms, the value of a deductible expense is higher when you're in the 35% bracket than if you're paying 25%, so it makes sense to pay more of your deductible expenses during years when your tax rate is high.
Doubling up on your deductible expenses can be an easy way to minimize your tax liability. Since you probably spend a significant amount of time tracking your deductions anyway, it takes only slightly more effort to manage the timing of your expense payments, and take advantage of every break the tax laws give you.
For more helpful hints, tips, and resources about taxes of all kinds, check out The Motley Fool's Tax Center. You'll find everything from basic information to articles about complex tax issues. The Motley Fool is dedicated to providing financial information of all kinds to its readers.
Fool contributor Dan Caplinger expects to itemize next year for the first time -- if real estate prices will just keep dropping. He doesn't own shares of any of the companies mentioned in this article. The Fool's disclosure policy won't leave you seeing double.