Income tax deductions are items that reduce your taxable income. But, there’s more to the story. It’s important to be aware that not all deductions are created equal.
For instance, some deductions can be taken “above the line” on your tax return. Above-the-line deductions are subtracted from your income before the adjusted gross income (AGI) is calculated for tax purposes. This would include items such as losses on a property sale, alimony payments and educational expenses.
However, the amount of above-the-line deductions you take, directly affects the amount and type of “below-the-line” deductions for which you’re eligible. Below-the-line deductions include any deduction reported on a line that comes after the AGI calculation on a return.
While both deductions ultimately reduce your taxable income, some can have a more favorable impact on your tax bill than others. In most cases, above-the-line deductions are the better choice. Here’s why.
You can take above-the-line deductions even if you don’t itemize.
The standard deduction is a fixed amount that’s based primarily on your filing status, which reduces your taxable income. This amount is higher if you or your spouse are over the age of 65 or blind.
Each tax season, you have the choice to deduct your actual itemized deductions or take the standard deduction. Typically the choice is determined by whichever amount is higher.
If your total itemized deductions are less than the standard deduction, you may not receive any benefit from a tentative itemized deduction.
Above-the-line deductions benefit you whether or not you itemize your deductions.
Above-the-line deductions reduce your adjusted gross income.
Your adjusted gross income is the amount listed on the bottom line of page 1 of your tax return. It includes all of your total income, including wages, business and rental income, capital gains, unemployment income, and so on. It also factors in any allowances for personal exemptions and itemized deductions.
Above-the-line deductions, while commonly referred to as a deduction, are technically adjustments to your income.
These adjustments include items such as traditional IRA contributions, moving and education expenses, alimony payments and the deductible portion of self-employment tax.
Above-the-line deductions can also refer to business deductions and losses. For example, a business expense reduces your net business income, which therefore reduces your total income.
But what’s so special about your adjusted gross income?
Quite a lot. Your adjusted gross income may be used for many calculations on your tax return.
For example, you can only deduct medical expenses as itemized deductions to the extent they exceed 10 percent of your AGI (7.5 percent if you or your spouse are over age 65).
Every dollar that reduces your AGI not only reduces your taxable income, but it may help you qualify for other deductions as well.
Various credits are limited by your adjusted gross income. In some cases, an adjustment may help you qualify for a credit or other tax perk that you would not receive otherwise.
For 2015, check out these common above-the-line adjustments to income.
- Certain business expenses of National Guard and reserve members who travel more than 100 miles from home
- Health Savings Account (HSA) deductions
- Moving expenses if you moved in connection to a job or business
- Deductible portion of self-employment tax (generally 50 percent of the tax)
- Contributions to Self-Employed retirement plans, SEP or SIMPLE individual retirement arrangements (IRAs) and Qualified Plans
- Self-employed health insurance deduction
- Penalty on early withdrawal of savings
- Alimony paid (but not child support or settlement)
- Deductible contributions to a traditional IRA
- Student loan interest paid on a qualified student loan for yourself, your spouse or your dependent
- Write-in adjustments, such as the Archer MSA deduction or jury duty pay you turned over to your employer because your employer paid your salary while you served
Some expenses can be deducted as above-the-line or as itemized deductions.
Most deductions fit neatly into above-the-line or itemized deductions. You don’t have to worry about where to deduct them.
However, sometimes you have a choice of where to deduct an expense.
For example, you can deduct the real estate tax paid on your home as an itemized deduction.
However, if you have a small business, you may qualify to deduct a portion of your real estate tax as a business expense.
In most cases, you’re better off taking an expense as a business deduction whenever possible. Not only is it an above-the-line deduction, but it may also reduce the amount self-employment tax you pay.
Another example is self-employed health insurance. As discussed above, health insurance premiums can be deducted with itemized deductions.
However, you must reduce your total itemized medical expenses, including insurance premiums, by 10 percent of your adjusted gross income (7.5 percent through 2016 if you are over age 65). This must be done before you include them with your itemized deductions. (TaxAct performs this calculation for you.)
If you qualify, you’ll benefit more by taking the self-employed health insurance deduction, which is an above-the-line adjustment to income.