Not all tax deductions are created equal. This is the story of above-the-line deductions, the ones that you probably take.
What Are Above-the-Line Deductions?
An above-the-line deduction is a tax deduction that you can take without itemizing. You can claim it while also taking the standard deduction.
Historically about 70% of taxpayers have taken the standard deduction. In 2019 the IRS expected that number to climb to around 90%. This makes above-the-line deductions among the most expensive in the tax code, since all taxpayers can qualify, but also the most relevant for that same reason.
To understand how this works we need to look at how Congress structures the tax code.
Tax Credits vs. Tax Deductions
There are two ways to reduce your tax burden once the money has been earned. Tax credits directly lower the taxes you owe on a one-to-one basis. For every $1 in tax credits you receive, your taxes go down by $1.
If tax credits reduce your taxes below zero, they create a negative tax burden and the government owes you money.
Tax credits are relatively rare. The overwhelming majority of incentives in the tax code are deductions. These reduce your taxable income, not your tax burden directly. You pay no taxes on each deductible dollar.
Just as importantly, deductions come off the top. A tax deduction reduces income at your highest tax bracket rather than starting from your lowest. (To understand this more thoroughly, take a look at our article explaining tax brackets.)
Unlike tax credits, a tax deduction cannot generate a negative tax burden. While deductions can lead to a refund of taxes already paid they cannot reduce your taxable income nor your net taxes owed below $0.
Tax Deductions - Examples
Let's say you are a single taxpayer who earned $75,000 in taxable income during 2019. Your tax brackets would look like this:
• $0 - $9,700: 10%
• $9,701 - $39,475: 12%
• $39,476 - $75,000: 22%
• Total Federal Income Taxes: $12,518.76
You would pay 10 cents per dollar on each dollar earned up to $9,525, then 12 cents on each dollar earned between $9,701 and $38,700, and finally 22 cents on each dollar earned between $38,476 and $75,000.
Now let's say you have $5,000 in tax deductions. Those tax deductions would reduce your taxable income starting with the highest bracket. So your new tax brackets would look like this (changes in bold):
• $0 - $9,700: 10% 970
• $9,701 - $39,475: 12%
• $39,476 - $70,000: 22%
• Total Federal Income Taxes: $11,258.16
The $5,000 in tax deductions reduced your final bill by over $1,000 because, instead of paying 22 cents on every dollar earned between $70,001 - $75,000, you kept all of that money.
The higher your tax bracket, the more valuable deductions become. To someone in the second tax bracket, a deduction is only worth 12 cents per dollar because that's the highest rate at which they pay taxes. To you, in this example, however, a tax deduction is worth almost twice as much because your highest tax bracket is worth much more.
The Standard Deduction
Tax deductions are defined as either "above the line" or "below the line" based on their relationship to the standard deduction.
The standard deduction is a tax deduction that every taxpayer can take if they choose. Its purpose is to amplify the progressive nature of the tax code. For taxpayers below the poverty line, it can reduce and potentially even eliminate their tax burden altogether. For others, it serves to reduce their tax burden in a substantial and meaningful way.
Unlike much of the tax code, the standard deduction is written as a block figure rather than a percentage of income. This is to ensure that it loses significance to higher earners. A married couple with a $50,000 household income can reduce their taxable income by almost half through the standard deduction. To a millionaire couple that same figure is virtually a rounding error.
What Is the Current Standard Deduction?
For 2019 taxes due April 15, 2020 the standard deduction table is:
• Single Payer - $12,200
• Married Payers, Filing Jointly - $24,400
• Married Payer, Filing Separately - $12,200
• Head of Household - $18,350
Note: Readers who search for "standard deduction in 2020" may see a number of websites that give slightly higher figures. This is because the standard deduction for tax year 2020 (taxes due April 15, 2021) has been calculated and adjusted upward. These are the correct figures for taxes due April 15, 2020.
Choosing the Standard Deduction
While most taxpayers take the standard deduction, not all of them do. The alternative is to take line-item, or "below the line," deductions.
Taxpayers who take line-item deductions cannot also claim the standard deduction. Instead they claim a series of other deductions which collectively lower their overall taxable income. Some of the most common below-the-line deductions include charitable contributions, the mortgage interest deduction and state income tax payments.
Understand that this is an all-or-nothing option. A taxpayer who takes any line-item deductions cannot take the standard deduction and vice versa. As a result, a taxpayer will only do so if their line-item deductions exceed the standard deduction. This is why relatively few taxpayers use this section of the tax code, particularly in light of the massive expansion of the standard deduction.
Take our example above again: you, as a single taxpayer, would qualify for an automatic $12,200 standard deduction. You would need at least $12,201 in qualifying below-the-line deductions to claim any of them. Otherwise you will take the standard deduction as it's worth more. (Technically you can claim line-item deductions that add up to less than the standard deduction. In practice, however, doing so would cost you money.)
This is what makes above-the-line tax deductions so valuable. You can claim them and the standard deduction at the same time. In the alternative, you can claim above-the-line deductions and line-item deductions at the same time.
Where below-the-line deductions only apply in practice to a small percentage of taxpayers, above-the-line deductions apply to everybody.
Deductions and Schedules
Taxpayers filing in 2020 should take note: many above-the-line deductions have either been eliminated or moved.
Legislation in 2017 changed the tax code, and the IRS redesigned the standard 1040. It shrunk the form down to approximately the size of a postcard, as promised during the Trump presidential campaign.
This is not due to simplification. In fact, the Republican party's 2017 tax bill arguably made the U.S. tax code more complex by adding (among others) new rules concerning S-corporation and pass-through taxation.
Instead, the IRS reduced the size of the 1040 by moving most of its information onto a series of new forms called Schedules One through Six. Some of the more common above-the-line deductions have been moved onto these forms, where an inattentive taxpayer might miss them.
Common Above-the-Line Deductions
The good news is that above-the-line deductions go hand-in-hand with that massive standard deduction.
The bad news is… well, there aren't that many of them. And there are fewer than there used to be, as the Tuition and Fees Deduction recently expired. And they're fairly specialized. Congress writes above-the-line deductions to serve very specific purposes. They can still come in handy though, so make sure you don't miss some of the most common and useful ones, including:
• Student Loan Interest - You can deduct up to $2,500 of qualifying student loan interest. "Qualifying" means that the loan is in your name and no one else has claimed you as a dependent. Understand that this only applies to the interest, not the payments themselves. That would require a capacity for shame on the part of the boomer generation.
• Retirement Contributions - Certain retirement accounts come with a tax-advantaged status. That means that you can deduct your contributions from your taxable income.
• HSA and FSA Contributions - Health Savings Accounts (HSA) and Flexible Spending Accounts (FSA) are both tax-advantaged forms of healthcare spending. You can deduct your contributions up to specified limits.
• The Self-Employment Tax - Freedom isn't free, and here in the land of the pioneer we've managed to put a price tag on it: 7.65%. That's how much taxes go up on those with the audacity to work for themselves. This is known as the self-employment tax. Technically the tax is 15.3%, but all employers pay half of that. Only people who work for themselves pay the whole thing, (the rate consists of two parts: 12.4% for Social Security and 2.9% for Medicare.) You can take your additional 7.65%, or half of the self-employment tax, as an above-the-line deduction.
• Military Moving Expenses - Prior to the 2017 changes all taxpayers could deduct moving expenses above the line if they moved for work. This is no longer true for most people. However Congress created a specific carve-out for members of the military, who can still take this tax deduction when moving as part of their employment with the armed forces.