In the last article, we arrived at adjusted gross income or AGI. AGI is a very important measure for a lot of other places in your tax return whether you qualify for some benefit or other, or maybe whether you phase out of a benefit.
However, AGI is not your taxable income. We have not yet arrived at the taxable income amount on your tax return. Below adjusted gross income are a couple of other reductions to income which are very beneficial to your overall tax liability.
One is the standard deduction or itemized deductions, whichever one applies, everybody gets one or the other. You don't get both.
And then there's a category called qualified business income or QBI. This came into play starting on the 2018 tax returns. It relates to business owners to reduce their income by providing a deduction based on a percentage of your business results which we spoke about in a previous article.
QBI has some complicated issues beyond the scope of this article but simply put you might get as much as a 20% reduction in taxable income from your business related activities.
For standard deductions versus itemized deductions, you either itemize or you get a standard deduction, you don't get both.
If you itemize your deductions, you're going to look at a variety of items that might qualify such as, medical expenses, taxes that you pay at the state level, mortgage interest that you pay on a mortgage (not the entire mortgage payment), and charitable contributions. These are the more common deductions that many people have.
Typically, your mortgage interest is the number one qualifier that pushes people into the category of itemizing versus standard deduction. Then it's followed by your state tax payment deductions, and then charitable contributions is what we typically see in that order.
If you do not reach the level where your itemized deductions exceed your standard deduction, then you will use the standard deduction. The amount of the standard deductions differ whether you're single or head of household or married filing jointly or married filing separately.
A lot of times you don't know which one is more beneficial until you’ve added up all the items and then you get to see which one might benefit you while doing your tax return.
Also keep in mind that if you do not get to take advantage of itemized deductions at the federal level you may get to on your state tax return.
Key tax planning considerations to maximize deductions to lower taxable income could include grouping your itemized deductions into certain years so that you can cross over the standard deduction limit into itemized deduction territory.
For example grouping charitable contributions or paying for large medical expenses all in one year vs spread over two years could provide a better tax deduction position.
One of the things that is very confusing to a lot of people working on a tax return is this topic of whether an expense is tax deductible or not.
I constantly see people trying to promote a seminar or solicit charitable contributions say that it will be tax deductible when in reality it MAY be deductible. So beware of what I call the yahoos on you tube that give tax advice but won’t be there at your side to defend you when that advice or deduction gets challenged by a tax agency during an audit.
As we just saw above, if you are getting the standard deduction you get no additional deductions for whatever it is they want you to spend money on.
If it’s a worthwhile expense or contribution that’s a decision to make but use caution when someone tells you that an expense is tax deductible because it may or may not be on your tax return.
As a reminder if you do not reach a level of itemized deductions that exceed your standard deduction, then you get the larger standard deduction on your tax return which is a pretty good deduction for not having actually spent that much in deductible items.
Next up we’ll be talking about taxable income, taxes owed and tax payments.
If you think you may be overpaying taxes and not getting adequate advice from your current finance team lets set up a call.
The information in this and other articles is intended to be educational in nature only. Not tax, legal or investment guidance for you specifically. Each person’s situation is unique and you must seek appropriate professional guidance that can address your unique situation.