contributed by Nathan Gehring
“I can deduct this expense, so it’s not that bad.” “I need a mortgage for the tax deduction.”
I hear a variation of these quotes with some regularity.
But how valuable is that deduction really? I’ve had many discussion with people in which it became clear that they really didn’t fully understand what that value was. This misunderstanding generally happened because the individual didn’t quite grasp the play between the standard deduction and itemized deductions.
The Standard Deduction
When determining the value of itemized deductions, it’s important to first understand the standard deduction. Individual taxpayers are allowed a standard deduction against taxable income without having to incur any real life expenses. In 2014, this standard deduction is $6,200 for individuals and $12,400 for those married filing jointly. Taxpayers are allowed this deduction simply by virtue of filing a tax return. This should be considered an individual’s minimum deduction.
The Itemized Deduction
The itemized deduction is quite different than the standard deduction. To claim an itemized deduction, an individual taxpayer must first incur expenses which are allowed to be itemized. These commonly include unreimbursed medical expenses, state income tax payments, mortgage interest expenses, real estate taxes, and charitable contributions among many others. Some of these expenses are allowed to be fully deducted, others are limited in one way or another. For many taxpayers, these expenses can add up to considerable amounts and provide a large tax deduction.
However, there is an important thing to remember when considering expenses that can become itemized deductions. A taxpayer doesn’t receive a penny of tax savings on expenses allowable to be deducted until the expenses are sufficiently high enough to exceed the standard deduction available. In other words, a married filing jointly taxpayer only begins to save taxes through itemized deductions once those deductions exceed $12,400!
For many, this standard deduction hurdle isn’t too difficult to overcome. Add up state income taxes, mortgage interest, real estate taxes and that’s often enough to begin itemizing instead of taking the standard deduction.
But what’s that deduction really worth at this point? Just overcoming the hurdle doesn’t offer much in the way of tax savings. For example, consider a taxpayer with itemized deductions of $14,000. They would choose to itemize because $14,000 is greater than $12,400, thus resulting in a smaller taxable income amount and ultimately less tax. But the $14,000 in expenses would only have added $1,600 in extra deduction over what was available for free! $1,600 extra deduction at even the highest marginal tax rate (39.6%) would only reduce taxes payable by $634. $14,000 spent resulted in a tax decrease of $634 dollars. And for many taxpayers in lower tax brackets, that savings may be closer to $160 (10%) to $400 (25%).
For many, overcoming the hurdle isn’t that easy. The hurdle can be pretty steep to individuals who live in states that do not impose a tax or who rent their primary residence. These individuals simply don’t have some of the largest expenses to itemize; state income taxes, mortgage interest and real estate taxes.
Itemize but Realize
Itemized deductions can reduce total taxes due for individual taxpayers. One should certainly consider itemizing when their itemized deductions exceed the standard deduction. But it is important to realize that, just because an expense is allowed as an itemized deduction, doesn’t mean the deduction will be all that valuable. It is critical to understand that only itemized deductions in excess of the standard deduction actually result in tax savings. And then, the value is only the amount of itemized deductions in excess of the standard deduction. Expenses for the sake of a tax deduction may be less valuable than believed.