Income
Deductions and exemptions are two important elements of our tax system. In order to manage your taxes successfully, it is key that you have an understanding of how both work and fit into the larger picture.
DEDUCTIONS
Deductions are simply expenses that you can subtract from your adjusted gross income before you compute your taxable income. By lowering your taxable income, you reduce the amount of taxes that you owe.
There are two ways to determine your deductions.
Thankfully, though, you get to choose the method that gives you the best solution -- whichever way offers you the most deductions. The two methods are:
HerTip: Deductions and exemptions may become phased out the higher your income. Make sure you compute your proper deductions before including them on your return.
1. Standard deduction
A standard deduction is the easiest way to go and is a set amount that the government allows you to take. Almost everyone who files a tax return qualifies for the standard deduction. If you do not earn a high income, live in a rented house or apartment, and lack unusually large deductible expenses such as medical bills, state and local income taxes, or loss due to theft or catastrophe, you can probably file a standard deduction on your tax return.
- There generally is a fixed standard deduction you may claim based on your marital status, age, or disability status.
- The amount is adjusted annually to account for inflation. As of 2004, for most people 65 or younger, it was $4,850 for a single woman, $9,700 for married couples filing a joint return (or qualified widows), $4,850 for married couples who file separately, and $7,150 for a head of household.
2. Itemized deductions
The second method of determining your allowable deductions is itemizing them on your tax return. This method certainly requires more work, but it could save you money. These deductions must be listed separately and documented carefully. There are a number of common itemized deductions that you should be aware of. Click here for a full list.
- Medical and dental expenses
- State and local income or sales taxes, and some foreign taxes
- Interest expenses
- Charitable donations
- Casualty and theft loss
- Job expenses and most other miscellaneous expenses
Let's take a closer look.
1. Medical and dental expenses
In most cases, you may be able to deduct some of your un-reimbursed medical expenses that exceed seven and a half percent of your adjusted gross income.
- Deductible medical expenses include insurance for medical, dental, and long-term care, prescription medicines or insulin, medical doctors, medical examinations, dentists, nursing help, hospital care, and medical aids such as eyeglasses, contact lenses, hearing aids, braces, crutches, wheelchairs, and guide dogs.
- Medical treatments considered for cosmetic or quasi-medical reasons, or treatments not prescribed by a doctor, are not deductible.
HerTip: travel for medical treatments may also be included
2. State, local, and some foreign taxes
On your federal tax return, you can deduct income taxes, sales taxes or real estate taxes you have paid to your state, your locality, or sometimes a foreign government. Personal property taxes paid to your state or local government are also tax deductible.
3. Interest expenses
Interest you've paid is generally tax deductible in the following three situations:
- Interest on a home mortgage -- Interest on your mortgage for a first or second home is generally deductible. A second home may include a vacation home, a houseboat, or a motor home. Points on a mortgage refer to the up-front fees charged by lenders on a mortgage. Points are deductible over the term of the loan, but could also be deductible in a lump sum the year you pay them.
- Investment interest -- Deductible investment interest generally includes interest paid or charged to you on margin accounts to brokerage firms. Investment interest is generally deductible up to the amount of net investment income you earn that year. If you pay more in investment interest than you earn in investment income from your stock, bond, or mutual fund holdings, you can carry the excess interest forward to offset next year's investment income.
- Interest on student loans
4. Charitable donations
Gifts to qualified charities can not only help someone in need, but it can also help reduce your taxes significantly. To receive your tax deductions, you must follow a number of rules.
- In 2004, if you gave over $250 to most qualified organizations, you must get a written receipt from the organization to substantiate your claim.
- If you donate non-cash items with a value over $500 to a single organization, ask for a receipt and attach the Form 8283 to your 1040.
- If you donate enough non-cash items to one organization to claim a deduction of more than $5,000, you must attach a written appraisal supporting your claim (most major charities can provide you with one).
- The amount you deduct in a given year for charitable contributions may be limited, and depends on the form of payment and type of charity.
- If held for more than twelve months, you can deduct the market value of stocks and bonds, regardless of what you paid for them.
- You can also deduct the fair market value of donations of clothing, household appliances, furniture, and other goods to charities. Just make sure to keep some documentation -- write up an itemized list and get it signed by the charity.
- If you donate used motor vehicles, there are special limitations based on the value and the charity to which they are donated.
HerTip: You can also deduct expenses for work you do with charitable organizations. For example, if you work in a hospital, you can deduct transportation costs to get there. You just need to keep track of your bus fares or driving mileage.
5. Casualty and theft losses
If you have experienced a major property loss due to damage or theft, and you are not reimbursed by your insurance policy, you may qualify for a deduction.
- You must take a deduction in the year the loss occurred.
- Damage loss includes sudden events such as a hurricane or tornado, rather than a slow deterioration over a period of time.
- To claim a theft, you should file a stolen property report with the police department or obtain testimonials from witnesses.
- You should not claim a theft deduction unless you can prove the property was stolen.
- The amount of the loss should be documented with cost and appraisal records.
6. Miscellaneous expenses
Certain expenses, including many related to your job and career, are classified by the IRS as "miscellaneous deductions." When you deduct miscellaneous expenses, you only get to deduct the total of these costs that exceed two percent of your adjusted gross income. Some miscellaneous expenses include:
- Educational expenses related to your career
- Job search and career counseling
- Un-reimbursed expenses related to your job
- Investment and tax-related advisor fees
In addition to these deductions, there are a number of lesser known deductions that are often overlooked. Don't forget that the more you can subtract, the more you can reduce the amount of your taxable income. (Click here for some of the more commonly overlooked deductions)
EXEMPTIONS
Exemptions enable the taxpayer to take a deduction from adjusted gross income. You may be able to get at least one exemption for each person in your household. There are two main types of exemptions: personal exemptions and exemptions for dependents:
1. Personal exemptions.
Personal exemptions fit into six main categories:
- Exemption for single taxpayers
- Exemption for married couples filing jointly or qualified widow(er)s
- Exemption for married couples filing separately
- Exemption for heads of households
- Extra exemption for self or spouse aged sixty-five or more
- Extra exemption for self or spouse who is blind
Note: Above certain income levels exemptions are phased out.
2. Exemptions for dependents.
There are five tests that must be met for a person to qualify as your dependent. (click here for a list of tests)
Conditions of dependent exemptions are subject to many exceptions and special interpretations; the definition used to determine a dependent in some respects is also scheduled to change slightly for the 2005 tax year. We recommend you seek professional advice when dealing with some of the more complex issues.
Continue to: IV. Credits
*WFN at Siebert and Muriel Siebert & Co., Inc. do not provide tax advice.
Basic Tax Concepts