- Above-the-line deductions, such as traditional IRA and health savings account (HSA) contributions, are subtracted right from your total income.
- Below-the-line itemized deductions, such as mortgage and home equity loan interest and charitable donations, reduce taxes based on your tax rate.
- Tax credits, like the Earned Income Tax Credit and the Child and Dependent Care Tax Credit, reduce the tax you owe.
Literally hundreds of potential federal tax breaks are out there for the taking. Don't miss out. Get to know the different types of deductions and how they're handled when filling out your tax return—and keep good records—so you can potentially lower your taxes.
Although "tax deduction" is often used as a catch-all, there are 3 types of tax reducers: above-the-line deductions, below-the-line itemized deductions, and tax credits. Let's dig into each.
1. Above-the-line deductions reduce your income
Tax deductions come in 2 basic types: "above-the-line" and "below-the-line." The "line" is your adjusted gross income, or AGI. Above-the-line deductions are subtracted from your total income, thus lowering your AGI. Lowering your AGI means you’ll have less income to pay taxes on but there are some other advantages as well. Another advantage is that many above-the-line deductions are allowed under the alternative minimum tax, or AMT.
A lower AGI can potentially increase the value of your below-the-line itemized deductions, which often come with limits. For example, you can deduct your medical and dental expenses, but only the amount that exceeds 7.5% of your AGI and only if you itemize deductions on your federal tax return. So the lower your AGI, the quicker you hit 7.5% and can start deducting. You can’t claim these expenses if you take the standard deduction which, for 2017, is $6,350 for taxpayers who are single or married filing separately, $12,700 for married filing jointly, and $9,350 for heads of household (single taxpayers with dependents).
Beginning in 2018, the standard deduction is $12,000 for single filers and married individuals filing separately. Joint filers get a deduction of $24,000 while the deduction for head of household filing is $18,000.
Some above-the-line deductions:
Contributions to retirement accounts: As long as you are eligible,1 contributions to a traditional IRA are subtracted from your gross income, enabling you to reduce your 2017 taxable income by as much as $5,500 per qualified taxpayer, or $6,500 if you're 50 or older. Self-employed individuals can deduct contributions to a Simplified Employer Pension, or SEP, up to 25% of pretax income, (20% of net self-employment income reduced by half of self-employment tax if you are self-employed) capped at $54,000. Contributions to a qualified workplace retirement plan, such as a 401(k) or 403(b), have essentially the same tax-lowering effect, but they are not technically tax deductions, since they are not counted as current-year income and therefore do not appear on your tax return. Contribution limits for 401(k) plans in 2017 are $18,000 for taxpayers under 50 and $24,000 for those 50 and above. In 2018, you can contribute up to $18,500, or $24,500 for people over 50.
Health savings account contributions: If you have a health savings account (HSA), aim to contribute the max: $3,400 for an individual and $6,750 for a family for 2017. The limit increases to $3,450 in 2018, and goes up to $6,900 for a family. Plus an extra $1,000 if you are age 55 or older.
An HSA offers potential triple tax benefits.2 Your contributions can be made with pretax dollars so you reduce your current taxable income; earnings on the investments in an HSA are not taxed; and withdrawals are tax free if used to pay for HSA-qualified medical and health care expenses. Another bonus: If you contribute to your HSA through payroll deduction, the money is excluded from income taxes and FICA taxes.
Student loan interest: For 2017, filers can deduct up to $2,500 in student loan interest, but this is one of the few above-the-line deductions that has an income limit. The deduction begins to phase out when modified AGI rises above $65,000 (single) or $135,000 (married filing jointly).
Teachers’ out-of-pocket expense: This popular deduction enables educators to deduct up to $250 of out-of-pocket costs for purchasing classroom supplies for 2017 and 2018.
2. Below-the-line itemized deductions reduce your tax based on your marginal tax rate
Itemized deductions are what most people think of when they hear "tax deduction." They include things like home mortgage interest, charitable contributions, and medical expenses. A $100 deduction reduces your tax by your marginal tax rate: For example, if you're in the 28% tax bracket, deducting $100 from your taxable income will generally lower your tax bill by $28. But itemizing deductions only makes sense if the total amount of your deductions exceeds the standard deduction.
Some below-the-line deductions:
Mortgage interest: Interest and "points" paid on a home mortgage, generally including a second home, are often the largest itemized deductions available to taxpayers.
There are some limits to the mortgage deduction. If you took your mortgage before December 15, 2017, you may be eligible to deduct the interest on up to $1 million borrowed. But, for loans written after December 15, 2017, you can only deduct interest paid on mortgages of up to $750,000.
Beginning in 2018, the deductibility of interest paid on home equity lines of credit (HELOCs) has been eliminated by the Tax Cuts and Jobs Act. There is an exception for interest-deductible HELOCs available to homeowners provided they qualify on 2 criteria: They use the proceeds of the loan to make "substantial improvements" to their home, and the combined total of their first mortgage balance and their HELOC or second mortgage does not exceed the new $750,000 limit on mortgage amounts qualified for interest deductions.
Medical and dental: Only out-of-pocket medical and dental costs that exceed 7.5% of your AGI are tax deductible. After tax year 2018, the threshold for deducting medical and dental expenses will rise to 10% of AGI for all taxpayers as a result of the Tax Cuts and Jobs Act of 2017. In addition to after-tax health insurance premiums that you pay (not those paid by your employer or paid by you from a pretax payroll deduction), you generally can deduct the cost of dental work, eye care (including reading glasses, prescription eyeglasses, or contact lenses), non-traditional medicine, and medically related transportation. Prescription medications are also deductible, but most non-prescription items are not. You generally cannot deduct any medical and dental costs that you pay for from a pretax Flexible Spending Account for health care. For more information, read IRS Publication 502.
Planning ahead for eligible medical expenses may also help you maximize this deduction. By bunching your medical costs into a single year, you can increase your chances of exceeding the 7.5% in the year 2018.
Contributions to charity: Deducting charitable contributions requires good recordkeeping. Of course organization is key when it comes to getting the most from itemized deductions no matter the category. From front-door solicitations to donations at the supermarket or pet store checkout, opportunities to give abound—and add up. Online and smart device apps can help track spur-of-the-moment contributions, although you still need to have records in the form of a canceled check or bank or credit card statement, showing the date, amount, and name of the recipient.
For contributions of $250 or more of any kind, you're required to obtain a written acknowledgement from the charity. For donations of clothing and household items, the rules have gotten stricter for the condition of the items and the documentation. Be sure to know the rules before you donate and take photographs of valuable items.
Travel for charitable activities is also deductible at 14 cents a mile in 2017. Again, good records are a must, both for documenting your trips and for simply remembering that you took them.
Another investment-related tax strategy that many investors overlook is contributing appreciated assets to charity. If you're planning to give to a charity anyway, you could contribute stock that has gone up significantly in value, which enables you to deduct the fair market value of the stock at the time of the contribution while avoiding capital gains taxes. It's a double win. Read Viewpoints on Fidelity.com: Increase your tax savings on charitable giving.
State and local taxes: Taxpayers have a choice to deduct either state and local income tax or state and local sales tax (but not both). Deducting sales tax can be a big help if you live in a state with low or no income tax, but keeping track of sales tax can be challenging.
Note that after tax year 2017, the deduction for state and local taxes is limited to $10,000—including property taxes.
You have 2 options for taking the sales tax deduction: You can tally up all the sales tax you actually paid, or you can use the federal sales tax deduction calculator to come up with what the IRS considers a reasonable estimate, including the option to enter the amount of any actual sales tax payments on big-ticket items such as the purchase or lease of a vehicle, boat or aircraft, or on substantial home improvements.
Miscellaneous deductions: These include tax preparation fees, job-search expenses, gambling losses, unreimbursed job expenses (think uniforms and subscriptions to professional journals), and more. Most miscellaneous deductions are subject to the "2% rule," which means that you can only deduct the amount of the expenses that exceeds 2% of your AGI. How well you track these expenses during the course of the year can make the difference as to whether you reach the threshold. Read IRS Publication 529 for more.
At least you won't need to track expenses so closely in 2018—miscellaneous deductions were eliminated by the new tax law.
3. Tax credits are subtracted from the tax you owe
Credits lower your tax dollar for dollar because they are subtracted from the tax you owe; a $100 tax credit lowers your tax by $100. Many taxpayers overlook them because they think their income is too high to qualify. That might be true in some cases, but here are some potentially beneficial tax credits:
Earned Income Tax Credit (EITC): This credit is for working people with low-to-moderate income. It varies based on income, how you file, and the number of dependents you have. It can be worth up to $6,318 in 2017 and $6,444 in 2018. Find out more on the IRS page about the Earned Income Tax Credit
Child and Dependent Care Tax Credit: Designed to help working families pay for child care, this credit is available to taxpayers in all tax brackets with some restrictions. Taxpayers with AGI of $15,000 or less can claim 35% of qualified expenses up to $3,000 for one dependent child and $6,000 for 2, while taxpayers with AGI over $43,000 are limited to 20%. Between the 2 thresholds, the percentage is gradually reduced. For complete rules, read IRS Publication 503, Child and Dependent Care Expenses.
American Opportunity Tax Credit (AOTC): This credit of up to $2,500 per year is available for qualified education expenses paid for an eligible student for the first 4 years of college. The credit begins to phase out at a modified AGI (MAGI) of $80,000 for single taxpayers or $160,000 for married joint filers, and you cannot claim the credit if your MAGI is over $90,000 (single) and $180,000 (joint). It's important to note that there are several education-related credits and deductions, so if you plan to claim the AOTC, be aware that "double dipping" isn't allowed.
Lifetime Learning Credit: This credit is for qualified tuition and related expenses paid for eligible students enrolled in an eligible educational institution. This credit can help pay for undergraduate, graduate, and professional degree courses—including courses to acquire or improve job skills. To claim the full credit of $2,000, or 20% of up to $10,000 in eligible expenses, your 2017 MAGI cannot exceed $56,000, or $112,000 if you are married filing jointly. If your MAGI is over $56,000 but less than $66,000 (over $112,000 but less than $132,000 for married filing jointly), you receive a reduced amount of the credit. If your MAGI is over $66,000 ($132,000 for joint filers), you cannot claim the credit. There is no limit on the number of years you can claim it. You are also eligible if your spouse is the student and you're filing jointly. For more information, see IRS Publication 970, Tax Benefits for Education.
Take a look
Chances are good that there are tax deductions and credits that may help you reduce your taxes. The key is knowing where to look, keeping good records, and planning ahead to maximize their value. We've highlighted the common ones, but it makes sense to work with a tax professional for guidance too.