Personal Deduction Planning
Taxes, like death, are inevitable. But why pay more than you have to? The trick to minimizing your federal income tax liability is to understand the rules and make the most of your tax planning opportunities. Personal deduction planning is one aspect of tax planning. Here, your goals are to use your deductions in the most efficient manner and take all deductions to which you're entitled.
Deductions lower your taxable income
Your first step is to understand how deductions work. You subtract certain deductions from your total income to arrive at your adjusted gross income (AGI). Then, you subtract other deductions and exemptions from your AGI to determine your taxable income. Your tax liability is calculated based on your taxable income. Generally speaking, therefore, the higher your deduction level, the lower your tax liability.
You can either take a standard deduction or itemize
After you've computed your AGI, you'll want to subtract the greater of either the standard deduction or the total of your itemized deductions. The standard deduction is a fixed dollar amount, indexed for inflation yearly, that is determined according to your filing status (e.g., married filing jointly, single) and certain circumstances. Itemized deductions are various deductions that are reported on Schedule A of your federal tax return (Form 1040). They involve certain personal expenses, such as medical expenses, mortgage interest, state taxes, charitable contributions, theft losses, and miscellaneous itemized deductions. If you have enough of these types of expenses, your itemized deductions may exceed your standard deduction. In that case, it would be to your advantage to itemize.
When filling out your tax return, how do you know whether to take the standard deduction or itemize? You should calculate your taxes using both methods, and go with the one that lowers your tax liability the most. Be aware that there are some limitations regarding who can use the standard deduction and who can itemize. Also, certain itemized deductions are available to you only if your expenses exceed a particular percentage of your AGI. For example, miscellaneous itemized deductions are allowed only to the extent that they (when totaled) exceed 2 percent of your AGI. So, if your AGI is $100,000, your first $2,000 of miscellaneous itemized deductions won't count toward your total itemized deductions. Your medical expense deduction may also be limited by your AGI.
The medical and dental expenses deduction: what it is, and how it involves your income level
The medical and dental expenses deduction is an itemized deduction that you may take (within certain limits) for unreimbursed medical and dental expenses you paid during the year for yourself, your spouse, and your dependents. You may be surprised to learn which medical and dental expenses are deductible and which are not; the line is sometimes blurry. For example, you can't deduct your expenses for nicotine gum, but you can deduct your fee for a smoking cessation program. Many expenses qualify for this deduction, including acupuncture treatments, crutches, eyeglasses, and prescription drugs. You should obtain IRS Publication 502, Medical and Dental Expenses, for an authoritative list of eligible and nondeductible expenses. If you don't review this list, you may miss out on some important tax-saving opportunities.
You can take this deduction only to the extent that your unreimbursed medical expenses exceed 7.5 percent of your AGI. That might sound complicated, but here's how it works. First, add up your eligible medical expenses. You can deduct only part of that total on Schedule A of your federal income tax return. The schedule will actually lead you through this calculation. On that form, you'll multiply your AGI by 7.5 percent (.075). The figure you come up with will represent the amount of your medical expenses that you cannot deduct. Subtract this figure from your total eligible medical expenses. The remaining amount is your medical deduction.
Your itemized deductions may be limited if your income is too high
Many deductions are affected by your AGI. If you itemize your deductions, you should be aware that some of your deductions might be limited or disallowed if your income level is too high. How high is too high? Well, the amount of your allowable itemized deductions may be limited if your AGI exceeds $159,950 (in 2008) for most filers, or if it exceeds $79,975 (in 2008) and your filing status is married filing separately.
If you expect that your AGI will exceed the threshold this year, you may be able to take steps to lower your AGI. You can try to lower your AGI by deferring (postponing) part of your income to next year, buying investments that generate tax-exempt (rather than taxable) income, and contributing as much as you can to qualified retirement plans. Lowering your AGI may allow you to take full advantage of your itemized deductions. This, in turn, will help reduce your tax liability.
Note: For tax years beginning after 2009, the limitation on itemized deductions for higher-income individuals is repealed by the Economic Growth and Tax Relief Reconciliation Act of 2001. The repeal is being phased in over a five-year period that began in 2006. When the repeal is complete, a taxpayer will no longer have to reduce the amount of his or her itemized deductions when AGI exceeds threshold amounts.
Proper timing of your deductions will minimize your taxes
For most people, income is reported in the year that it's received, while deductions are generally taken for the year in which expenses are paid. In many cases, you can control whether you incur an expense this year or next. That means that you can control the timing of your itemized deductions to some extent. If you're in a higher income tax bracket this year than you expect to be in next year, you may want to accelerate your deductions into the current year to minimize your tax liability. You can do this by paying deductible expenses before year-end and making charitable contributions before year-end. For example, if you have major dental work scheduled for January of next year, you can reschedule for December to take advantage of the deduction this year. Here are some tips:
· If you pay a deductible expense by check, make sure it's dated and mailed before year-end. It needn't clear the bank by year-end, however.
· If you pay by credit card, the expense is deductible in the year the charge is incurred, not when the credit card bill is paid.
· A mere pledge or promise to make a charitable contribution is not deductible.
· Along with your cash contributions to a charity, remember to deduct noncash contributions like clothes. You can also deduct mileage if you use your car for charitable purposes.
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