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Types of Income Tax Deductions

Most people understand that reducing their tax burden is an easy way to improve their finances. And most people understand that a significant part of reducing their taxes is claiming every deduction for which they’re eligible.

Unfortunately, many people don’t fully understand that there are multiple types of deductions and that, depending on the circumstances, some deductions may be of limited value–or no value at all!

“Above the Line” Deductions

The first type of deduction is the “above the line deduction.” These deductions are particularly valuable because (assuming you meet the applicable requirements) you can claim them regardless of whether you itemize or use the standard deduction (which we’ll discuss in just a minute).

One easy way to know that something is an above the line deduction is that it appears on the first page of Form 1040. Some of the more common above the line deductions include:

Itemized Deductions

The next primary group of deductions are itemized deductions. Every year, you have the choice to claim either a) the standard deduction or b) your itemized deductions. In other words, itemized deductions are only valuable if they–in total–exceed the standard deduction.

The standard deduction amount changes per year, and it depends on your filing status, your age, and whether or not you are blind. (See here for 2011 standard deduction amounts.)

Some of the more common itemized deductions include:

  • Home mortgage interest,
  • State and local income taxes,
  • Real estate taxes, and
  • Charitable contributions.

2% Floor, Miscellaneous Itemized Deductions

Next, there’s a sub-category of itemized deductions known as “miscellaneous itemized deductions, subject to the 2% AGI floor.” This means that they’re only deductible to the extent that they–in total–exceed 2% of your adjusted gross income. (Your adjusted gross income is the last line on the first page of your Form 1040.)

In other words, it’s possible that you won’t be able to deduct these at all–even if you do itemize your deductions.

Common miscellaneous itemized deductions, subject to the 2% AGI floor include:

Other Assorted Deduction Limitations

Finally, many deductions have limits on the amount that you can deduct and/or limits on the amount of income you can earn before you become ineligible for the deduction. For example, student loan interest is deductible as an above the line deduction, subject to two limitations:

  • The total amount of the deduction cannot exceed $2,500, and
  • If your modified adjusted gross income exceeds $60,000 ($120,000 if married filing jointly), the amount of the deduction you can claim is reduced. Once your MAGI exceeds $75,000 ($150,000 if married filing jointly), you cannot claim the deduction at all.

Other deductions have their own completely unique rules. For example, medical expenses are an itemized deduction that you can only claim to the extent that they exceed 7.5% of of your adjusted gross income.

What to Know About a Deduction

In order to determine whether or not a deduction will save you money on taxes, you first need to know:

  • Is it an above the line deduction or an itemized deduction? (Or is it a different type of deduction entirely–a deduction you’d claim on Schedule C as a sole proprietor, for instance?)
  • If it’s an itemized deduction, do you have enough itemized deductions to exceed your standard deduction?
  • Does the expense/loss have to exceed a certain amount (a “floor”) before you can deduct it?
  • Is there a limit to the amount you can deduct? (And is that limit affected by your income?)
  • And, if you’re subject to the Alternative Minimum Tax, is the deduction allowed for AMT purposes as well?

For More Information, See My Related Book:

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Taxes Made Simple: Income Taxes Explained in 100 Pages or Less

Topics Covered in the Book:
  • The difference between deductions, exemptions, and credits,
  • Itemized deductions vs. the standard deduction,
  • Several money-saving deductions and credits and how to make sure you qualify for them,
  • Click here to see the full list.

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Comments

  1. @Mike – Can you elaborate on how MAGI is calculated?

  2. Hi Michael.

    MAGI is adjusted gross income (the bottom line of the first page of Form 1040), modified in some way or other, depending on what deduction/credit/etc. we’re talking about.

    For example, according to IRS Publication 970, for purposes of the student loan interest deduction, MAGI is your adjusted gross income before subtracting any of the following deductions/exclusions:
    -student loan interest deduction,
    -tuition and fees deduction,
    -domestic production activities deduction,
    -foreign earned income exclusion,
    -foreign housing exclusion,
    -foreign housing deduction, and
    -exclusion of income by bona fide residents of American Samoa or Puerto Rico.

  3. In other words, it’s your AGI before being modified for all of the other deductions receiving special treatment/limitations outside of the norm. Always was curious about that, but the IRS literature was a pain in the backside to figure out (that’s why tax software exists, right?). Thanks for the quick reply.

If you want to discuss this article, I recommend starting a conversation over at the Bogleheads investing forum.
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