I often hear major confusion around standard and itemized deductions.
When I hear people talk about itemizing, many think it means splitting business expenses into categories or different line items. Many also think they are eligible for endless itemized deductions.
However, itemized deductions have nothing to do with your business. Business expenses and itemized deductions are two totally different things. Individuals who don’t own a business can still itemize deductions.
The confusion and lack of education around a simple but important topic makes me cringe 😬. Let’s set the record straight.
To help, let’s use the idea of a menu. You can order one main dish. In this case, it’s either the standard or the itemized deduction entrée, but never both. Portion control, people.
What’s the Difference Between the Standard and Itemized Deduction?
To start, let’s look at line 12 on Form 1040, the U.S. Individual Income Tax Return. You’ll see standard deduction or itemized deductions in bold letters. That should be a hint.
A taxpayer can take either the standard deduction or itemized deductions.
Not both. One or the other. No matter which is chosen, you receive a tax deduction. Said in a different way, there is a tax benefit to both.
So which is the most beneficial? It depends on your tax situation. Can every taxpayer choose either way? No. Every taxpayer can take the standard deduction. Not every taxpayer can itemize deductions.
Let’s dig into the details.
What Is the Standard Deduction?
Every taxpayer is eligible for the standard deduction, which is the same amount for each taxpayer. The standard deduction amount changes slightly from year to year, as it’s adjusted yearly for inflation. If you go back to line 12 of the 1040, you’ll see a box to the left. The box shows you the standard deduction for 2020.
The standard deduction varies for the different filing statuses, for example whether you are single, married, or head of the household to name a few. On a side note, to see the different filing statuses and their corresponding amounts, you can look at the top of the 1040.
In 2020, the standard deduction for single or married filing separately is $12,400, married filing jointly or qualifying widow(er) is $24,800, and head of household is $18,650.
As you can see, the standard deduction for a single person is $12,400. For a married couple, the standard deduction is double the amount or $24,800 ($12,400 per individual). The IRS cuts an individual filing as head of household a little extra break.
These numbers are determined and set in stone by the IRS.
They don’t change much. It’s clear cut. Simple enough.
The standard deduction nearly doubled under 2017’s Tax Cuts and Jobs Act (TCJA). As a result, more people are taking the standard deduction and fewer are itemizing.
What Are Itemized Deductions?
I believe the best way to learn about itemized deductions is to look at the tax form. Itemized deductions are reported on Schedule A. Just like the other tax forms we’ve discussed in previous articles, itemized deductions also come with their own set of IRS instructions. Take some time to look at the form and instructions.
Let’s review the schedule and work our way down.
You’ll see the following bolded categories of expenses. Let’s focus on the most common: medical and dental expenses, taxes you paid, interest you paid, and gifts to charity.
1. Medical and Dental Expenses
This category includes health insurance premiums, doctors, hospitals, dental, prescriptions, glasses, contacts, and hearing aids. This list is not all-inclusive, but these are the most common healthcare-related expenses.
These expenses are deductible if they exceed 7.5 percent of your adjusted gross income (AGI).
Your AGI can be found on line 11 of Form 1040. To see this calculation, look at lines 1-4 on Schedule A. This is a technical calculation performed when preparing your tax return.
All this means is your total healthcare-related expenses are only deductible if they exceed a certain threshold. There’s a chance you can have health-care related expenses and none of them be deductible.
Take a look at the instructions for a more thorough list of potential deductions or consult with a tax advisor regarding the potential tax deductibility of other healthcare-related expenses.
2. Taxes You Pay
This deduction is limited to $10,000. The most common deductible taxes you pay are state and local real estate taxes, state and local income taxes, and state and local property taxes.
It’s worthwhile noting that this deduction was capped at $10,000 under the TCJA. In the past, the deduction was unlimited. This change has hurt individuals who pay a high amount of real estate taxes and state and local income taxes.
3. Interest You Pay
Home equity line of credit interest is tax deductible if the proceeds are used to improve your home. Some people use home equity loans to pay off credit cards, to pay for college, to consolidate debt, to pay for cars, etc. Interest is not tax deductible when the proceeds are used for these types of activities.
Limits apply for loans taken out on or before December 15, 2017. Interest is deductible on a mortgage up to $1,000,000 if your filing status is married filing jointly or $500,000 if your filing status is single or married filing separately.
If you took your loan out after December 15, 2017, the amounts differ. Interest is deductible on a mortgage up to $750,000 if your filing status is married filing jointly or $375,000 if your filing status is single or married filing separately.
The change in amounts was also enacted under the TCJA.
4. Gifts to Charity
You can deduct the amount of your contributions and donations to qualified charitable organizations. Most of the time, we use the terms charitable organizations and 501(c)(3) synonymously, but there are other types of charities that qualify. For more information about qualified organizations, check here. There are also some examples in the instructions.
5. Other Itemized Deductions
The one other deduction that I believe is worth pointing out are gambling losses. Gambling losses are deductible only to the extent of your gambling wins.
Here’s what the IRS says about gambling income: “Gambling income includes but isn’t limited to winnings from lotteries, raffles, horse races, and casinos. It includes cash winnings and the fair market value of prizes, such as cars and trips.”
Here are a few examples:
- If you have $1,000 worth of gambling wins and $1,000 worth of gambling losses and you itemize, you can deduct the losses.
- If you have $1,000 worth of gambling wins and $1,000 worth of gambling losses and you don’t itemize but choose the standard deduction, you can’t deduct the losses.
- If you don’t have any gambling wins and have $1,000 worth of gambling losses, it doesn’t matter whether you itemize or not. You can’t deduct the losses.
Once your Schedule A is complete, you will see the total amount of itemized deductions at the bottom of the page.
So How Do I Know If I Should Take the Standard or Itemized Deduction?
You already know what your standard deduction is by looking at your 1040. Now you know what your itemized deductions could be. Compare the two numbers. Which one is greater? That’s the one to choose.
This is tax. We want to pay the least amount of tax possible.
This means we are looking for the greatest amount of deductions to lower our taxable income.
Returning to our menu analogy, we want to pick the best meal for the least amount of money.
Some taxpayers may have few, if any, itemized deductions; others may have many. It’s worth comparing both scenarios. Taking the standard deduction is simpler and saves time.
Itemizing requires more recordkeeping, organization, and time. Remember, each taxpayer must take either the standard deduction or itemized deductions. It’s up to you to decide what is most beneficial.