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For many, tax planning is not a simple filing every April. Many Americans seek a more proactive approach and coordinate their tax planning with their full financial picture. On that note, it is common for many to seek deductions and credits to lower their taxable income, ultimately reducing their tax liability to the federal government. The most common deduction available to each taxpayer is the option to either take the standard, allowable deduction, or itemize their deductions. This blog seeks to break down these two options to help the taxpayer determine the deduction that allows the most on a case-by-case basis.
Before determining whether the standard deduction or itemized deductions make sense, adjusted gross income is calculated on one’s tax return.
One must first calculate the household’s total gross income to determine taxable income. Gross income comprises all wages, dividends, capital gains, rental payments, and pension payments, among many others. The two notable exceptions to gross income are any gifts or inheritance received. Once gross income is pooled together, it is important to note any above-the-line deductions which lead to the adjusted gross income. Examples of above-the-line deductions include Traditional 401(k) / Traditional IRA (if income allows for deduction) / SEP IRA contributions, Health Savings Account contributions, deductible self-employment taxes, and student loan interest (if income allows).
For example, let’s assume a client has a gross income of $500,000 (part is W2, and part is 1099 from their own business). If they contribute $22,500 to a Traditional 401(k) through their W2 income and $66,000 to a SEP IRA through their 1099 income in the same year, this client’s adjusted gross income would be calculated as $411,500.
Once the adjusted gross income is calculated, one can take the standard deduction or itemize their deductions.
The standard deduction is what the IRS allows as a dollar-for-dollar reduction to one’s taxable income. For single filers or those married filing separately in 2023, this equals $13,850. If married filing jointly, the standard deduction currently sits at $27,700. For those filing as head of household, the 2023 standard deduction is $20,800. There are additional standard deductions if one is over 65 or legally blind of $1,850 if filing single, or $1,500 if married filing jointly.
A taxpayer can choose the standard deduction or the sum of their itemized deductions– whichever is higher.
Itemized deductions include, among others:
For example, let’s assume a household is filing jointly for the 2023 tax year. Further, for 2023, they have state and local taxes due of $8,000, mortgage interest of $10,000, and make charitable contributions of $6,000. In this example, their itemized deductions for 2023 would equal $24,000. This is less than their standard deduction amount of $27,700, so this household would be better off taking the standard deduction. This couple may have thought they were getting tax breaks from their mortgage and charity (as an example), but in this case, they did not help with their tax return because of electing the standard deduction.
However, let’s assume the household is charitably inclined and wants to “batch” all their donations for the next few years in one donation (all in 1 year). By utilizing a Donor Advised Fund, the household could batch future donations into one year’s worth of contributions. Taking the previous example, let’s assume the household batches $6,000/year of donations for five years ($30,000 total all in 1 calendar year), along with their state and local taxes of $8,000 and mortgage interest of $10,000. Now, in 2023, their itemized deductions would equal $48,000.
In this case, $48,000 outweighs $27,700, and the household would itemize their deductions in 2023 before taking advantage of the standard deduction in subsequent years.
Being strategic in choosing the standard deduction vs. itemizing can lead to significant tax savings for households. Further, it can lead to a more proactive tax planning approach better coordinated with one’s entire financial plan. Before deciding on any tax deduction or credit, it would be wise to consult with a tax professional.
Please see the following resources of videos created around tax planning:
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