Death and taxes may be the only certainties in life, but if you understand how to maximize deductions and credits, you can lessen the impact of at least one of those two absolutes.
The first thing you need to know is that credits are different from deductions. A credit is a dollar-for-dollar reduction in your taxes, while a deduction simply reduces your taxable income. If you’re in the 25% tax bracket, a $100 deduction effectively saves you $25 on taxes.
It’s also important to understand that not all deductions are the same, notes St. Louis CPA Douglas Mueller. You can take what’s known as above-the-line deductions even if you opt for the standard deduction, as most taxpayers do. If you pay a lot in mortgage interest, state taxes or self-employment costs, among others, it might make sense to itemize (more on that later).
Tax preparation software — or a good tax preparer — can help you navigate the maze of tax breaks, but it helps to understand the picture as you go through the year, ideally collecting invoices along the way.
What not to do: “Don’t let the tax tail wag the dog,” says Mueller. In other words, don’t spend money on things you wouldn’t otherwise for the sake of a write off. “You might save 25 cents, but you still had to pay 75 cents,” he adds.
Get credits where due
In the hierarchy of tax breaks, credits give you the most bang for your buck. It’s worth repeating: Every $1 you claim as a credit equals $1 back in your pocket. The biggest categories for credits include children (and childcare), education and energy efficiency. These are some of the big ones.
- Child tax credit. This credit is worth up to $1,000 per child under age of 17 at the end of the tax year, but begins to phase out at $110,000 for married joint filers. If you’re divorced, only one parent can claim the credit, notes Rob Shelter, a Los Angeles CPA.
- Dependent care credit. Working parents can claim a credit of up to $3,000 for qualified childcare costs for children who are disabled or under age 13 at the end of the year.
- Savers credit. Joint filers with income under $55,000 ($27,500 for singles) can claim a credit of up to $2,000 ($1,000 for singles) for contributions to qualified retirement plans.
- Energy credits. Many energy credits expired in 2013 but credits for residential wind turbines, solar power and geothermal live on through 2016. Credits are worth up to 30% of the cost, with no cap.
- Education credits. The American Opportunity Credit (formerly Hope) is worth $2,500 of eligible post-secondary education costs for four years. The full credit is available for joint filers with less than $160,000 in adjusted gross income ($80,000 for single filers). You may also be able to claim the Lifetime Learning credit for other years.
Deductions don’t pack quite the same punch as credits, but they offer far more opportunities to save — and they add up. Above-the-line deductions not only reduce your adjusted gross income — which impacts everything from your tax bracket to qualifying for key credits — they’re available even if you take the standard deduction.
Some of the notables include, but aren’t limited to:
- Retirement-plan contributions. In addition to the any pre-tax contributions you make to a 401(k), you can deduct your IRA contributions; the limit is $5,500 ($6,500 if you’re over 50). If you’re self-employed, you can deduct up to $52,000 (or 25% of compensation) in SEP contributions for 2014. “That’s a huge tax benefit,” says Shelter.
- Student loan interest. You can deduct up to $2,500 in interest, though benefits begin to phase out for modified adjusted gross income over $120,000 for joint filers ($60,000 for single).
- Health savings account. This is a big one as more people move to high-deductible plans. Families with qualified plans can deduct up to $6,500 ($3,300 for single) for contributions made to HSAs. The money can be rolled over to other years and used for a range of qualified expenses.
- Moving expenses and job search. If you moved more than 50 miles for a job within a year of starting a new job, you can deduct expenses related to the move, including mileage, lodging moving services and supplies.
Itemized versus standard deductions
Once you’ve taken care of the above deductions, you can turn your attention to the second category of deductions. Here you have the option of itemizing these below-the-line deductions or claiming what’s known as the standard deduction.
The vast majority of taxpayers, roughly 70%, opt for the standardized deduction, which is $6,200 for single people and $12,400 for married people in 2014. Anyone can take the standard deduction, says Mueller, and it does not change with income. Caveat: If you’re subject to the alternative minimum tax, you don’t get to take the standardized deduction.
Among taxpayers who do itemize, however, the numbers are pretty substantial. In 2011, the most recent data, taxpayers who itemized had a total of $25,000 in itemized deductions, according to CCH.
How do you know which route makes the most sense? Start by looking at your largest itemized deductions — for most people that’s mortgage interest, property taxes and state taxes. If they come close to the standard deduction, odds are that it makes sense to itemize after you account for all the other breaks, notes Lisa Greene-Lewis, a CPA at TurboTax.
Here are key itemized deductions:
- Mortgage interest. You can deduct interest on your primary residence and a second home, if it’s used primarily for personal use. The deduction is only good for up to $1 million in combined loan balances. You can also deduct interest on home equity loans and lines of credit with limits up to $100,000.
- Mortgage points. If you buy a new home, you can deduct any points you pay to secure the mortgage in a single year. If you refinance, notes Greene-Lewis, you need to spread those points over the life of the loan — though you get to deduct them all at once if you refinance again.
- Taxes. Odd as it seems, you can deduct certain taxes, including property tax on your primary residence, and state and local income taxes. What about sales tax? That deduction — which lets tax payers deduct state and local sales tax in lieu of income tax — expired at the end of 2013.
- Self-employment expenses. This is a category unto its own. Suffice it to say, if you are self-employed, the odds are pretty good that you will benefit from itemizing your deduction.
- Charitable giving. In 2011, taxpayers with adjusted gross income between $50,000 and $100,000 deducted $2,881 in charitable contributions. The key thing is to document your gifts; TurboTax offers an app that calculates fair market value of goods and tracks donations on the spot. Do you do a lot of volunteering? “You can deduct any mileage or out-of-pocket expenses,” says Mueller. “But you can’t write off the value of your time.”