In America, we love our tax deductions. We may despise the tax code, and find it anything but user-friendly – but don’t touch our cherished deductions. Much of that is born out of the history of the tax code. For decades, high marginal tax rates and generous deductions, affected the way we spent money and even how we lived our lives. But be careful – income tax deductions ain’t what they used to be.
It’s entirely possible that you could make major purchase decisions based on an assumption of tax deductibility the doesn’t actually exist, or is at least far less beneficial than you believe.
Higher standard deduction
The standard deduction has crept progressively higher over the years. It is now so high that many people who once itemized their deductions, now simply take the standard deduction.
For 2013, the standard deduction for single filers $6,100, and for married filing jointly, it’s $12,200. That’s a large deduction that tends to minimize what we think the benefits of certain tax deductions are.
As an example, let’s say that you’re considering buying a house and you want to take advantage of the mortgage interest tax deduction. The mortgage will be $300,000, which at a 4% interest rate, means that you’ll pay $12,000 in interest in the first year. In addition, you will have $4,000 in real estate taxes to pay. That means that you will have $16,000 in deductions when you file your income taxes, right?
Not necessarily. If you’re married filing jointly, you already have $12,200 (the standard deduction) in deductions without even having to itemize. In reality, your net tax deduction as a result of buying a home will be only $3,800 ($16,000 – $12,200). Now you may have other deductions that affect the bottom line, such as state income taxes paid and charitable contributions, but you get the point. The deduction that you’ll get as a result of buying a home will not be nearly as great as originally anticipated.
In addition, as the mortgage balance is paid down, and the interest paid on the loan decreases, even less of the house payment will be effectively deductible. Contributing to this declining deduction will be future increases in the standard deduction.
Lower income tax rates
Lower marginal tax rates are a major win for taxpayers in general, but they also degrade the value of deductions. Below are the marginal tax rates for taxpayers who are married filing jointly or single for 2013:
Married filing jointly:
- 10% – 0 – 17,850
- 15% – 17,851 – 72,500
- 25% – 72,501 – 146,400
- 28% – 146,401 – 223,050
- 33% – 223,051 – 398,350
- 35% – 398,351 – 450,000
- 39.6% – 450,001 and up
- 10% – 0 – 8,925
- 15% – 8,926 – 36,250
- 25% – 36,251 – 87,850
- 28% – 87,851 – 183,250
- 33% – 183,251 – 398,350
- 35% – 398,351 – 400,000
- 39.6% – 400,001 and up
Let’s see how low tax rates do their part to erode the value of tax deductions. Taking the example of the homebuyers above, let’s say that it’s a couple with two dependent children earning $85,000 per year. Since there are four people in the family, they will also each get a personal exemption of $3,900, or $15,600 (4 x $3,900). That reduces their taxable income to $69,400 ($85,000 – $15,600).
Looking at the tax brackets above, we see that the marginal tax rate for a couple, married filing jointly, at this income level is 15%. Let’s see how that impacts the tax deductibility of their $16,000 in combined mortgage interest and real estate taxes.
Since only $3,800 will be deductible ($16,000 less the $12,200 standard deduction), how much will they save in income taxes in their first full year in the home?
Just $570 ($3,800 X the 15% marginal tax rate)!
As you can see, the higher standard deduction and lower marginal tax rates have reduced what was once a very generous housing subsidy to just a few hundred dollars per year.
The medical deduction threshold is being raised – again
One specific deduction that’s continuing to be whittled away is the deduction for medical expenses. Through 2012, you could only deduct medical expenses (paid out of pocket) to the extent that they exceeded 7.5% of your adjusted gross income (AGI). For 2013, that threshold is rising to 10% of AGI. Our couple above would only be able to deduct medical expenses to the degree that they exceed $8,500 ($85,000 X 10%) in 2013. That will be a tough number to reach if you have even half-way decent health insurance.
Who itemizing works best for
You can no longer assume that you’ll get a benefit from itemizing tax deductions. Because of the high and rising standard deduction, millions of people can no longer itemize their deductions at all. This is particularly true of people who have a relatively low mortgage balance (a $100,000 mortgage at 4% results in mortgage interest deduction of just $4,000, and doesn’t come close to the standard deduction), or for retirees who have little to deduct to begin with.
But itemizing continues to be valuable to single people, people with high mortgage balances, and high income people who are married filing jointly. A married couple with an income greater than $146,401 (28% tax bracket) and a high mortgage balance would get a substantial tax benefit from itemizing.
Reduced deductions should change your financial habits
When you actually sit down and crunch the numbers you may be unpleasantly surprised at how little you are benefiting from itemizing your deductions. This isn’t as bad as it sounds because tax rates are fairly low. But the small benefit from itemizing – if you even can itemize at all – should affect your spending habits. Creating expenses to gain tax deductions may not be as generous as they seem.
You can no longer assume, for example, that buying a new home will automatically result in a tax deduction windfall. The notion that tax deductibility is subsidizing your new, higher house payment may be mostly wrong. In addition, if you are looking to lower your taxes, you should concentrate more on “above the line” deductions (deductions that will lower your taxable income before itemizing). This will include IRA’s, Health Savings Accounts, and self-employed retirement plan contributions.
Income tax deductions—at least for itemizing—aren’t as generous as they used to be, and that should change a few things.