Standard vs. Itemized Deductions, and Ways to Reduce your Taxes for 2018

I've gotten a couple of phone calls recently from folks asking me to explain the new tax plan to them.

In case you haven't heard, a huge tax bill called the Tax Cuts and Jobs Act was signed into law on December 22, 2017.

 I'm not interested in engaging in politics on this blog, but there are some strong feelings running around about the tax bill.  Many folks are confused about what a lot of it means.

While I'm not going to dive into things like C Corps and Pass Through Entities right now, I thought it might be helpful to explain the basics of the standard deduction and itemized deductions. Those will be changing, and it is difficult to plan without understanding their basic mechanics.

The new tax bill takes effect for income that you earn between January 1, 2018 and December 31, 2018. You'll file taxes on that by mid-April 2019. So if you were worried about the tax return you were going to file in April 2018... chill out for just now!

The standard deduction will be doubled, and many itemized deductions are going away, but many people aren't sure what that means for them.

Before I get into talking about the new tax bill, I want to talk about something that isn't changing: how the choice between a standard deduction and itemizing works.

Itemize, or take the Standard Deduction?

When you file your individual taxes, there are a few deductions that anyone can take. Those are called "Above the Line Deductions". For the rest, you must make a choice. You have the option to either:

A. Itemize, that is, list your deductions and take the sum total of those listed costs or
B. Take a flat, "standard" deduction.

Here's an example:

In 2017, Joe had these activities:

  • $2000 of Charitable Donations
  • $300 of Student Loan Interest (one of those special above the line deductions)
  • $5500 of contributions to a Traditional IRA (another one of those special above the line deductions!)
  • $1000 of Mortgage Interest

Joe is single, so his standard deduction is $6350.

Joe can deduct his student loan interest no matter what. It is an "above the line deduction". Same thing with the $5500.

Now, he has to choose whether he wants to go with the standard deduction, or if he wants to itemize. Since his itemized deductions would total up to $3000, he would get a $3000 tax break if he itemized.

Itemized Deductions: $3000.
Standard deduction: $6350.

Which should he pick?

Obviously Joe should pick the standard in this situation! It is a much bigger tax break than $3000!

Now let's pretend that Joe's 2017 looked like this:

- $2000 of Charitable Donations
- $300 of Student Loan Interest (*Above the line deduction!)
- $5500 contributed to a Traditional IRA (*Above the line deduction!)
- $5000 of Student Loan Interest

Joe will get $5800 chopped off his taxable income no matter whether he chooses to itemize or not, from his above the line deductions.

If he itemizes, he will get an additional $7000 chopped off his taxable income.
If he goes with the standard, he will get $6350 chopped off his taxable income.

Here is a case where he will be better off itemizing for 2017!

Now you know how itemizing works!

Personal Exemptions

Personal Exemptions are going away for 2018. Many people confused personal exemptions with the health care penalty exemption, but they are two very different things.

Personal exemptions work a lot like deductions, but they are separate from your standard or itemized deduction.

What a personal exemption is - or, used to be- was an extra amount of money per each household member that was deducted from your taxable income.

For 2017, the personal exemption amount is $4,050 per household member: you, your spousse.

So, if you were married with two kids, you'd have $16,200 shaved off your taxable income in addition to your standard/itemized deductions and above the line deductions. Not bad! This will be missed in 2018, although the child tax credit has been increased so that large families suffer a little less from the Tax Cuts and Jobs Act.

Above The Line Deductions - or "WTF is an AGI"

Remember those Above the Line deductions? There are many of them, and they are like special, superpowered deductions. Why? Because you can take these deductions and still take the standard deduction right on top of them too!

Their magic goes beyond that, though. When you take these deductions, your AGI goes down. AGI stands for Adjusted Gross Income. It means that the IRS has decided that when you have these deductions, it's like you never made that money at all.

With some modifications, (this number is called MAGI, and the modifications are, specifically, adding back certain kinds of tax-exempt interest- something most folks won't have.) AGI is used to determine things like your Obamacare subsidy.

Here's a screenshot from a real life 2016 Form 1040, a.k.a Individual Income Tax Return, listing the Above the Liners:

This may change for 2018, specifically alimony and that domestic production activities part.

Here is an oversimplified example using 2016's numbers:

  • Bob makes $40,000 at his job. His gross income is $40,000.
  • He has $1,000 in Above the Line deductions. His Adjusted Gross Income is $39,000.
  • He takes the standard deduction for a single person: $6,300. He has one personal exemption: $4,050.
  • Bob's 2016 taxable income is now $28,650.

Personal exemptions are going away for 2018, but the standard deduction is going up- this has a major cancelling out effect for Bob's taxes next year.

Lots of people who were getting very excited over the doubled standard deduction were not aware that their personal exemptions ($4,050 for each household member) were going away.

Since Bob does not itemize, he will probably see a modest tax decrease from the new bill, depending on how 2018 goes for him. Nothing life changing, but not an increase.

How Changing the Standard Deduction Affects Those Who Would Otherwise Itemize

For tax year 2018, the standard deduction is going way up. This makes it less worthwhile to do things which generate deductible costs (which aren't above the line!)

Same thing goes for mortgage interest, which is also an itemized deduction.

  • Some itemized deductions, like theft and casualty losses, will no longer be allowed, unless you're in a Federal disaster area. 
  • Unreimbursed employee expenses are also going away. Please note- this does not affect your deductions if you are an independent contractor!! You will still deduct your business expenses on a schedule C! Employees are people who have taxes withheld by their employer and receive a form w-2 at the end of the year. Independent contractors may receive a 1099, keep track of their own income, and pay taxes like a business.
  • Others, such as State and Local taxes, will be capped.

So, for a single person, instead of needing more than $6300 of deductions to make it worth it to itemize, you'll now need $12000. On top of that, many of the deductions are going away or have capped amounts.

You'll have to donate a lot more to charity for it to matter- or, I'm sure, many people will choose not to donate and take the higher standard deduction instead.

How to Reduce your Personal Taxes in 2018

Here are some possible ways to reduce your taxes for 2018:

Plan ahead if you're an itemizer. If you're planning to donate a ton of money or property to charity, buy a home with a mortgage, or move to a high state/local tax area, have a plan. Take enough of the deductions that will still be around to make it worth it to itemize.

Fill up a traditional 401(k) and/or IRA: This is an above the line deduction, and will reduce your AGI and taxable income. Added bonus- if you qualify for an Obamacare subsidy, it will decrease the income number they base your subsidy off of! This doesn't work for Roths, though, since you fill those with after-tax money.

Another added bonus: You'll have a better life when you're 59.5, and some insulation if they gut Social Security to pay for the tax cuts and jobs act!

Pay hard on your student loans in 2018. Student loan interest remains deductible. If your current payments aren't big enough to cover the interest as fast as it accrues, upping your payments will help get you off the debt hamster wheel as well as upping your tax deduction.

Max out an HSA. The Tax Cuts and Jobs Act made no changes to HSA deductions, another above-the-liner. HSAs are great stuff. This is a good basic read on what they are.

Do you have any thoughts about the 2018 changes to your tax return? Let me know in the comments!

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