✔ 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 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 three types of tax reducers: above-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 two 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. 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 10% of your AGI (7.5% if you or your spouse is 65 or older) and only if you itemize deductions on your federal tax return. So the lower your AGI, the quicker you hit 10% 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).
Some above-the-line deductions:
IRA contributions: 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 of 25% of their income, 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.
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, plus an extra $1,000 if you are age 55 or older, for 2017. 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.
Student loan interest: The IRS has not released the 2017 number, but in 2016 you 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 if your modified AGI rises above $65,000 (single) or $130,000 (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.
2. Below-the-line itemized deductions reduce your tax based on your 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 and home equity loan interest: Interest and “points” paid on a home mortgage, generally including a second home, are often the largest itemized deductions available to taxpayers. Plus, you can also deduct interest on a home equity loan or line of credit. Although if you’re subject to the AMT, home equity loans and lines of credit are only tax deductible if they’re used to buy, build, or improve your home.
There are some limits to the mortgage and home equity interest deduction. If the total of all your mortgage debt for buying, building, and improving your home is more than $1 million, you generally cannot deduct the full amount of the mortgage interest you pay for the year. Also, you generally can deduct home equity loan interest only on debt up to $100,000 for married joint filers.
Medical and dental: Only out-of-pocket medical and dental costs that exceed 10% of your AGI (7.5% if you’ve reached age 65) are tax deductible. 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 10% in that year.
Contributions to charity: Deducting charitable contributions requires good recordkeeping. 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 cancelled 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 stock 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 to you 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: "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.
You have two 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, then add in 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.
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.
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 two, while taxpayers with AGI over $43,000 are limited to 20%. Between the two thresholds, the percentage is gradually reduced. For complete rules, read IRS Topic 602, Child and Dependent Care Credit.
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 four years of college. The credit begins to phase out at a modified AGI of $80,000 for single taxpayers or $160,000 for married joint filers, and it disappears at $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 applies to education expenses, as well as job training. To claim the full credit, your 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. 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.