For the second year in a row, the IRS has extended its deadline for filing taxes. You'll have until May 17, 2021 to get your 2020 tax returns completed. So, have you started? Are all those anxious thoughts swirling around yet? Like, do you have all the paperwork? What form do you need again? Deductions and credits -- huh?
The many concerns surrounding tax time can be boiled down to main questions:
1. Are you prepared?
2. How can you save more money?
Maybe you've decided to go with a tax preparation service or a professional tax preparer to help you sort it all out. Or maybe you have decided to go at it alone with tax software or some other online tax tool. Either way, you have taken the first step toward getting your taxes done. But how can you save more money by shaving some dollars off that tax bill? Two words: Tax deductions.
What are tax deductions?
Maybe you have heard the phrases before: "You can write those things off on your taxes" or "those expenses are deductible." If you have spent any time researching tax filing you have certainly run across the term, tax deductions. This term can change the amount of taxes you owe and help you pay less on Tax Day.
Tax deductions have the ability to lower an individual's or business's tax liability by reducing their taxable income. Taxable income is the amount of gross income the government deems subject to taxes -- both earned and unearned. In basic math terms: Subtracting tax deductions from taxable income lowers that taxable income and in turn lowers the taxes owed. Simple enough, right?
Standard deductions vs. Itemized deductions
Now that we better understand tax deductions let's look at the two types: Standard deductions and itemized deductions. It is important to note that when you are filing your tax return you have to choose between these two tax deductions. You cannot choose both. Let's look at each briefly.
Some say this is the easiest option when claiming deductions. It also involves the least amount of work. The standard deduction is automatically set based on how you file your taxes (married filing jointly, married, or single) and age. Depending on the type you choose to file, the amount of taxes is automatically reduced. For example, here are the standard deductions for 2020 taxes to be filed in 2021, per the IRS:
- $12,400 for single taxpayers
- $12,400 for married taxpayers filing separately
- $18,650 for heads of households
- $24,800 for married taxpayers filing jointly
- $24,800 for qualifying widows or widowers
Note: These deductions are for federal taxes -- each state has its own tax laws and standard deductions.
The standard deductions are fixed, so there's no need to pull out the receipts. However, if you have the time, significant expenses, and enjoy crunching numbers then the itemized deduction might be for you. Itemizing deductions is much more labor-intensive because you have to claim expenses one by one. In addition, it requires an additional form (Schedule A form) to be filed along with your tax return. You have to be able to back up the claims you are making on your itemized deductions.
Itemized deductions are expenses that are subtracted from adjusted gross income, having the same goal as the standard deduction in reducing taxable income and lowering the amount of taxes owed. The amount depends largely on the tax bracket the tax filer falls into.
The itemized deduction does have its perks. Examples of some expenses that can be itemized would be educational expenses, dental expenses, and medical expenses (over 7.5% of adjusted gross income), investment interest, and gambling losses. Examples of things you cannot itemize as expenses would include tax preparation expenses, natural disaster losses, and unreimbursed employee expenses.
The best tax deductions in 2021
Reduce taxable income, reduce and lower taxes. That is the name of the game in tax deduction. Now that we better understand tax deductions -- and the two types that tax filers must choose from -- let's look at the most common tax deductions available to you when preparing your 2020 tax returns.
Student loan interest deduction
Student Loan Interest is a popular deduction among all college graduates (and their parents), especially among those with massive student loan debt. Paying back student loans can be quite a long and grueling process, but the student loan interest deduction does offer a little relief.
This deduction allows filers to deduct up to $2,500 from taxable income if they paid interest on a qualifying student loan, either for themselves or a dependent.
There are qualifications, of course, student loan deduction depends largely on modified adjusted gross income (MAGI) and the respective tax bracket. For example, if a filer's MAGI is less than $85,000, or $170,000 if filed jointly, then student loan interest paid on both federal and private student loans can be deducted. Here are a couple of examples of the criteria:
- Education of others: If the loan was taken out in your name for someone else (for a child or dependent) a deduction is permitted.
- Education expenses: If the loan was used for qualified education expenses like tuition, books, housing, and transportation.
- Forced repayment: Even if you are legally obligated to repay the loan or if wages are being garnished to repay the interest can still be deducted.
Note: Most federal student loans were suspended in March 2020 due to the pandemic but the interest paid before that time can still be deducted from 2020 tax filings.
Home office and self-employment deductions
The ongoing pandemic has changed the face of work. Due to the circumstances, many employees were forced to work from home while others used the opportunity to start their own home-based businesses. What many do not know is that there are tax deduction opportunities for self-employed, freelancers, and others who work from home.
Let's look at a few of these opportunities to save money this tax season.
Home office: These days many people are using their homes as their office. Home office deductions could provide some tax relief. Property taxes, rent or mortgage, cost of utilities, and repairs could all have an impact on tax savings. Per IRS Publication 587, a percentage of your home's square footage, the part used for business-related activities, could be deductible.
For instance, if your home office takes up 15% of your home's square footage, then 15% of your home's expenses could be deducted from taxable income. Make sense? Check out the publication above for a more thorough explanation.
Vehicle: Maybe part of your day consists of meeting clients or vendors. The expenses that come with using your vehicle can be deducted too, roughly $1 for every two miles traveled when used for business-related activities. So keep a mileage total. At the end of the year, the number of miles driven for business can be multiplied by the IRS mileage rate and be deducted from taxable income.
Credit card and loan interest: Self-employment tax deductions might be hiding on those credit card statements, so keep them handy. Accrued interest on those business-related purchases can be deducted.
Self-employment taxes can become tax deductions: Yes, even self-employment taxes (rate of 15.3% of net earnings) can be deducted as a business expense, half of it at least. For example, if you owe $4,000 in self-employment taxes, come tax time $2,000 would qualify as deductible on your Form 1040.
Medical expense deductions
Some medical expenses are also deductible, qualified, unreimbursed expenses that are more than 7.5% of your adjusted gross income (AGI). For instance, if your AGI is $60,000, any medical bills that go beyond the first 7.5% of your AGI -- $4,500 -- can be deducted as a medical expense. So, if you had $10,000 in medical bills, then $5,500 could be tax-deductible.
A full list of qualified medical expenses is available on the IRS website. Some included would be hospital and nursing home care, payments to doctors, dentists, surgeons, and prescription drugs.
During tax season most people are concerned with whether they are prepared and if they can save more money. Tax deductions are one way to help save you money during tax, that is if you understand them, how they work, and which ones apply to you.
Tax deductions can lower an individual's tax liability by reducing taxable income. This reduction in taxable income directly affects and lowers the amount of taxes owed. As we have seen, there are only two options for tax deductions; standard deductions and itemized deductions. Standard deductions are set deductions by the government based on filing status while itemized deductions require more work from the filer as they must calculate various qualified expenses in a given year.
There are many deductions out there to be had and applied to lower your taxable income. Knowing the best ones may help you save more money during tax season.