Most people have a notion that there's a lot of stuff they can deduct, but don't quite know when or how to do so. That confusion can lead to higher taxes. So here's the skinny:
Deductions lower your taxable income. The lower your taxable income, the lower your tax bill. The vast majority of Americans take what's called the standard deduction, which is available to everyone.
For 2002 returns, the standard deductions are:
- $4,700 for single filers;
- $7,850 for married couples filing jointly;
- $6,900 for head-of-household filers;
- $3,925 for married couples filing separately.
But some taxpayers -- particularly those who pay a lot of mortgage interest and/or have high state tax bills -- can often benefit from itemizing their deductions. If the amount of all your itemized deductions exceeds the applicable standard deduction, you're better off itemizing. To do so, you'll need to list the deductions on Schedule A of Form 1040.
(Some deductions that are available to some taxpayers whether they itemize or not. For more on these so-called above-the-line deductions, see
Deductive Reasoning -- How to Get the Most From Your Tax Deductions.)
Itemized deductions are not unlimited -- if your 2002 adjusted gross income exceeds $137,300, some of your itemized deductions will be reduced. (Deductions for medical expenses, casualty and theft losses, gambling losses and investment interest expenses won't be reduced.) Your deductions will be reduced by 3% of the excess AGI over $137,300.
In other words, let's say your AGI is $177,300 and you have deductions for mortgage interest, charitable contributions and state and local taxes amounting to $20,000. The AGI excess over $137,300 is $40,000, so your itemized deductions will be reduced by $1,200 (3% of $40,000). You'll be allowed to deduct just $18,800 instead of the full $20,000.
Getting Your Deductions in a Bunch
Not all deductions are simply dollar-for-dollar reductions of your taxable income. Some need to be grouped (or "bunched," in common tax parlance) to meet a certain level before they're deductible.
Medical expenses, for instance, must exceed 7.5% of your adjusted gross income before they're deductible. In other words, if your AGI is $100,000 and you have $10,000 in
medical expenses, you can take a $2,500 deduction -- that's the amount that exceeds 7.5% of your AGI, or $7,500. (For more on deducting medical expenses, see
Deductions for Your Health and Your Wealth.)
Also, certain so-called miscellaneous itemized deductions must exceed 2% of your AGI before becoming deductible -- although you're allowed to bunch different kinds of miscellaneous deductions to meet that requirement. The most common miscellaneous deductions include investment expenses; business expenses; job-related education; job hunting costs; work clothes and uniforms; and legal advice. None of the above is deductible if you've been reimbursed or are eligible for reimbursement.
These deductions have strict definitions -- for instance, brokers' commissions and other costs directly related to buying or selling an investment are not deductible, because the costs are added to the purchase or sale price of the investment (which makes it a capital gains issue, not an income tax issue). You can, however, deduct investment advice fees, tax preparation expenses, certain investment-related travel costs, and any relevant books, subscriptions and software.
Job-related education expenses are only deductible if the education maintains or improves skills needed for your current job, or if your employer or the law requires the education in order to keep your current salary. Any education that helps you return to a job or qualifies you for a new job isn't deductible.
Similarly, expenses incurred in looking for a new job in your current field are deductible, while the cost of finding a job in a new field are not deductible. If you qualify, though, you can deduct fees paid to employment agencies or career counselors; transportation and travel expenses (including meals and hotels) for trips to look for a new job; as well as petty costs such as printing and mailing resumes.
Work clothes are only deductible when specifically required by an employer and not suitable for ordinary wear. (In other words, police uniforms are deductible; your new Armani suit is not.)
A Separate Peace
There are few reasons for married couples to file separately, but itemized deductions could warrant such a move. If you and your spouse have a significant amount of medical expenses or miscellaneous deductions, but they don't quite exceed the requisite percentage of your joint AGI, consider filing separately.
Filing separately essentially means that you and your spouse file separate returns, reporting only your own income. (The tax brackets for those who are married but filing separately are exactly half of the brackets for joint filers.) Because each of you will have a lower adjusted gross income, reaching that 7.5% (or 2%) threshold will be easier. And the tax code allows the spouse with the lower AGI to deduct all the medical expenses for the other spouse, as well as any dependents.
There are a few caveats, though. For one, when filing separately, both spouses must either claim the standard deduction or both must itemize -- and so it still might work out better if you file jointly; you'll just have to do it both ways and see. Also, some tax credits -- such as the $1,500 Hope credit or the $1,000 Lifetime Learning credit (which can be used to defray higher education expenses), as well as the earned income tax credit (a credit aimed at the working poor) -- cannot be claimed by married couples filing separately. You must file jointly to be eligible.