Don’t worry – the IRS doesn’t want to tax every last cent you earn.
In fact, it offers a standard deduction — a gift! — to all taxpayers based on their filing status.
For the 2016 tax year, the standard deduction for a single filer under the age of 65 can automatically deduct $6,300 from their taxable income, and a married couple filing jointly can deduct $12,600 ($6,300 married filing separately).
But, depending on your finances, you may lower your tax burden even further if you itemize deductions.
Written into the tax code are allowances for all kinds of deductible expenses.
When you choose to itemize deductions on your federal income tax return (the famous Form 1040), you attempt to claim legal deductions that add up to more than the standard deduction This is done in hopes that you get a bigger refund or have a smaller tax bill. See our blog post of the difference between itemized and standard deductions here.
Before you jump into itemizing your deductions, keep in mind it requires careful financial record-keeping and a close reading of the tax rules. However, going this route can pay off come April 18.
Most common deductions:
This is a great benefit for homeowners whose monthly mortgage checks include huge chunks of interest. By itemizing deductions, you can deduct 100 percent of the mortgage interest you paid. For more information check out our post of the interest expense deduction.
State and local taxes
This one makes sense; why should the federal government tax you on earnings that you’ve already spent on state and local taxes?
In the seven states that don’t have income tax, residents can choose to deduct sales tax instead.
Charitable gifts and donations
As a way of rewarding charitable giving, the IRS lets taxpayers deduct the cash value of donations given to charities that are tax-exempt organizations.
The total charitable giving deduction is capped at 50 percent of adjusted gross income (AGI).
Medical and dental expenses
The IRS recognizes the high cost of health care and allows a partial deduction of out-of-pocket medical expenses (not health insurance premiums).
The deduction covers the portion of medical expenses that exceed 10 percent of your income (7.5 percent if you’re over 65).
Additional deductible expenses
You can also deduct other costs, like non-reimbursed job expenses, theft and casualty losses, tax preparation fees and gambling losses.
The generosity of the IRS does have its limits, though. The tax code applies floors, ceilings and phase-outs for certain itemized deductions.
Floors set a minimum amount at which you can start deducting certain expenses, such as medical expenses in excess of 10 percent of AGI. That 10 percent is the floor.
There’s a whole category of miscellaneous expenses that only count if they amount to greater than 2 percent of AGI.
Ceilings impose a limit on certain categories of itemized deductions, like the limit on charitable deductions to 50 percent of AGI.
Additionally, you can only deduct 50 percent of the cost of business-related meals and entertainment. And, gambling losses can’t exceed gambling winnings.
The phase-out of certain itemized deductions is reserved for the highest income earners.
For tax year 2016, the phase-out begins for individuals earning $259,400 or couples earning $311,300.
The phase-out applies to most of the popular itemized deductions, including mortgage interest, charitable donations, and taxes paid.
If your income exceeds those thresholds, the total amount of itemized deductions you can claim is lowered by 3 percent of every dollar over the limit, up to a maximum 80 percent reduction.