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How Deductions Work and When You Should Consider Bunching Them

The 2017 Tax Cuts and Jobs Act introduced many changes to tax law. For individual filers, the changes to how deductions work had the biggest impact: many commonly used deductions were reduced, limited or eliminated outright, and the standard deduction was increased to compensate. What’s a deduction anyway? Broadly speaking, taxes work like this:

  1. You add up all your income (see lines 1-8 of Form 1040)

  2. You apply some adjustments to that income, from Part II of Schedule 1, if relevant to you. These are known as above the line deductions

  3. This is your Adjusted Gross Income (AGI), which is an important number to know and has implications for your ability to make deductible or Roth IRA contributions, for example, among many other calculations.

  4. Out of your AGI, a deduction is applied, and filers can determine each year which of two deduction types is more beneficial to them: either the standard deduction or, if greater, the sum of itemized deductions.

  5. Standard deduction: for the 2020 tax year, the deduction is $12,400 for single filers, or $24,800 for married couples filing jointly.

  6. Itemized deductions: you can use Schedule A to add up the total you paid for things like state and local taxes, mortgage interest, charitable contributions, and medical expenses. If it’s higher than the above standard deduction, you can claim the higher amount. The biggest impact here was the new limit on how much of your state and local taxes (that means income taxes and real estate taxes) can be deducted: just $10,000.

  7. Your AGI - your deduction = your taxable income. This is the number on which how much tax you owe will be calculated. How much you paid throughout the year, either through payroll withholding or estimated taxes, is compared to this number to determine if you overpaid or underpaid.

Obviously the system is complex and each step has its own particular flavor of inscrutability, but that’s the general gist. And note that a deduction is not the same as the allowances you claim on your paycheck, though often the general public tends to use the terms interchangeably. Allowances were the way to manipulate the amount of tax withheld from your pay so that it would more closely align with your ultimate tax burden. The new Form W-4 has eliminated allowances in favor of a simpler method of determining withholding, though many payroll systems are still on the old standard.

In practice, many filers now find themselves close to, but not quite over, the standard deduction amount. Is there a way to make use of being on the cusp like that? Enter the strategy of deduction bunching!

The concept is simple: every other year, you prepay certain deductible expenses - such as making your January mortgage payment in December so you pay more interest this year, or making part of next year’s planned charitable contribution this year, to push your itemized deductions higher than the standard deduction amount. Then in alternating years, you claim the standard deduction. Over time, this has the effect of enabling more deductions, while not increasing your overall expenses.

Here’s an example:

Let’s say in 2020, you will pay a total of $12,000 in mortgage interest and plan to give $2,000 to your favorite charitable organizations. You will be able to claim $10,000 of state and local taxes as well, so your total itemized deductions would be $24,000. Since you’re married and you and your spouse file jointly, your standard deduction would be $24,800. But let’s say you pay your January mortgage payment early ($1,250 of it is interest), and also give $1,000 of next year’s planned charitable contributions early. Now your itemized deductions are $26,250, well above the standard deduction amount. If your AGI was $200,000, that can mean about $350 in reduced taxes.

So, if you find yourself in the close-but-not-quite-over zone, as a lot of you with mortgages might, it makes sense to consider whether this strategy might make sense for you. And as always, tax law is ever changing so it also makes sense to keep an eye on the rules around deductions, and what will shift in the future.


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