Ask the typical American his or her thoughts on paying taxes, and you'll probably get some sort of snarky answer. The truth is, none of us want to pay more taxes than we need to, and if you're smart about taking deductions, you could slash your tax bill and keep more of your hard-earned money for yourself.
As a quick refresher, deductions work by excluding a portion of your income from taxes. Unlike tax credits, tax deductions won't reduce your tax liability dollar-for-dollar; they'll simply prevent a portion of your earnings from being taxed. Furthermore, with a tax deduction, your actual savings will be based on your effective tax rate. If, for example, your effective tax rate is 25%, and you claim a total of $4,000 in deductions, you'll see $1,000, or 25% of that amount, in actual tax savings.
While there are loads of deductions available to taxpayers, here are five in particular you shouldn't forget.
1. The mortgage interest deduction
The mortgage interest deduction can be particularly lucrative for homeowners in the early stages of their mortgages. That's because when you first get a mortgage, the bulk of your payments are applied to the interest portion of your loan, as opposed to its principal.
Say you take out a $240,000, 30-year fixed mortgage at 4% interest. Your monthly payments will be $1,145, but of that, only about $350 will go toward your principal in the beginning. In fact, during your first year, you'll pay close to $800 a month in interest for a total of over $9,500, all of which you'll get to take as a deduction.
Now there is a limit as to how much mortgage interest you can deduct on your taxes, but most people don't hit it. You can deduct your interest in full provided your loan doesn't exceed $500,000 if you're a single tax filer, or $1 million if you're filing jointly.
2. Property tax deductions
Just as homeowners are allowed to deduct their mortgage interest, so too can they deduct what they spend on property taxes each year. And in some parts of the country, that deduction can be huge. Though the average American homeowner pays $2,127 a year in property taxes, in certain areas, that number can be five to 10 times as high. Take New Jersey, for instance, where property taxes are the highest in the nation, and the typical homeowner pays $8,353 a year. In fact, if your property taxes are high enough, they could translate into more tax savings than your mortgage interest deduction.
3. Medical expense deductions
Healthcare can be a major burden for working Americans and retirees alike. The good news, however, is that if you spend enough on medical costs, you may be eligible for some tax relief. In fact, you can take a deduction for medical expenses that exceed 10% of your adjusted gross income (AGI), including in-office copayments, prescription drugs, and travel to and from medical appointments. This means that if your AGI is $100,000 and you spend $12,000 on medical care, you can take a $2,000 deduction.
4. Deductions for charitable donations
Any time you donate cash or goods to a registered charity, you can take a deduction on your taxes. Keep in mind, however, that if you're donating goods, your deduction should represent the fair market value of the items you give away, not their original value. In other words, if you donate a used coat that you once purchased for $100, you can't deduct the full $100 because that's not what the item would sell for today.
You should also be aware that the IRS tracks data on charitable contributions and might audit your return if you take too high a deduction. For example, back in 2014, the average American earning between $100,000 and $200,000 took a $4,130 deduction for charitable contributions. If you earn $150,000 a year but take a $15,000 deduction, it could raise a red flag.
5. Deductions for retirement plan contributions
Funding a retirement plan isn't just a smart move for your future. If you put money into a traditional IRA or 401(k), you'll save a bundle on your taxes up front. Currently, workers under 50 can contribute up to $5,500 a year to an IRA and $18,000 a year to a 401(k). Workers 50 and older, meanwhile, get to contribute up to $6,500 to an IRA and $24,000 to a 401(k). If you're 30 years old with an effective tax rate of 25% and you max out your 401(k), you'll shave a cool $4,500 off your taxes.
The good thing about tax deductions is that they're not mutually exclusive; you can claim as many as you're eligible for. And the more deductions you take, the more cash you'll put back in your pocket.