Understanding Itemized Deductions
We define itemized deductions as a series of expenses with which one can reduce taxable income on a tax return. It includes medical bills, interest paid on the mortgage, charity donations, etc. Taxpayers that itemize will sum up all their expenses and deduct it from the adjusted gross income to get to the taxable income.
You can file federal tax income using form 1040, and you have the option of using either the standard deduction route or itemizing. If your itemized deductions are more than the normal deduction value, the best choice is to itemize.
One, however, needs to understand that there are some circumstances in which taxpayers cannot itemize or go through the standard deduction route. The non-resident alien must itemize, and married couples filing jointly need to itemize while couples filing separately must choose the same filing method.
Common Itemized Tax Deductions
State and local taxes
Gifts via check or cash
Real estate mortgage interest
Dental and medical expenses
Provided you can itemize, you need to keep track of everything you spent in the tax year alongside all documentation like a bank statement, medical bills, receipts, and letters from charities.
Here are Essential Rules and Limitations to Keep in Mind
Dental and Medical Expenses: One can only deduct out-of-pocket medical expenses which exceed 7.5% of the AGI in 2020
Local and State Income Taxes with property taxes: the deductions for state and local taxes were capped at $10,000 by the TCJA. Under past rules, the state and local deductions were unlimited.
Charitable Contributions: One can claim a deduction for property or cash donated to tax-exempt organizations that qualify
Theft and casualty Losses: You qualify to deduct losses from an incidence described as a disaster on the federal level
People that have been itemizing for a while will notice a couple of deductions from the list. Some tax reforms got rid of some miscellaneous itemized deductions like investment fees, tax preparation fees and job expenses.
Comparing Standard Deduction and Itemized Deductions
When the standard deduction amount designated for your filing status is more than the itemized deduction amount you can claim, it is recommended to take the normal deduction route. The reverse also applied.
An idea of the filing status, the itemized deduction you want to make for the year, and the rough estimate of the income is all you need to decide if you should go through the itemized deductions or the standard deductions. Considering your previous tax return can also help.
As an illustration, consider Olivia and Brian (married couple) who want to decide if they need to itemize in 2021. They expect their 2021 and 2020 tax return to be similar. Their adjusted gross income for 2020 was $200,000.
We will run through a list of deductions that can be itemized to know if Olivia and Brian will benefit from itemizing in 2021.
Dental and Medical Expenses
As mentioned, you can only benefit from itemizing medical expenses; the entire out of pocket dental and medical expenses should not be more than 7.5% of what you had in 2021.
They will need more than $7,500 to benefit from deductions and medical expenses for Olivia and Brian. If the couple has health insurance, but are healthy and have no major health procedures, they will have no more than $7,500 for medical expenses for 2021.
Local and State Taxes
Brian makes an estimated quarterly payment of $10,000 every year for state income taxes. Olivia does not make estimated tax payment as she stays home with their young son, neither does she have any income taxes withheld.
They paid $10,000 every year for their property taxes and $300 for their personal taxes alongside vehicle registrations. Of the entire $1300 paid in local and state taxes, the couples claimed $10,000. The extra $300 deduction is lost as the local and state deduction is capped at $10,000.
Mortgage Interest
The couple pays approximately $8500 each year as mortgage interest for their home. Their mortgage balance is below $600,000, and they use the entire proceeds to buy their house. This means Olivia and Brian need not worry about the mortgage interest.
Gift and Contributions to Charity
The couple donates approximately $650 in cash every year and another $250 worth of used furniture for clothing and household items to a charity group.
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