When is the right time to itemize your taxes?

Tax season can be a daunting time for many individuals, filled with confusing forms, numbers, and decisions to make. One of the critical decisions taxpayers face is whether to file with itemized deductions or opt for the standard deduction. Understanding the differences between these two approaches is crucial for anyone looking to minimize their tax liability and make informed financial decisions. In this blog, we’ll explore the distinctions between Itemizing Deductions and the Standard Deduction, so that you can choose the most advantageous filing method for your tax reality.

Background:

Mass income taxation was introduced during World War Two when the US realized we needed to fund the war effort.  Before then Federal Income tax, instituted in 1913,  was only paid by a few ultra-high income earners.  As you likely know the tax system is extremely complex and sensing this Congress introduced the first iteration of the standard deduction in 1944 which was a flat 10% deduction from income.  This remained the preferred practice for many years before moving it to a fixed dollar amount so that the lowest income earners would be exempted from income tax altogether, in fact, the standard deduction was even known as the low-income allowance for a few years.  During the 70s Congress decided to increase the standard deduction to keep up with inflation and in 2017 the TCJA Act nearly doubled the standard deduction to $12,000 for single filers and $24,000 for joint filers, this has continued to increase each year to $13,850/$27,700 in 2023.

This increase in the standard deduction made tax filing much simpler for the majority of Americans and now more than 90% of filers elect the standard deduction.  However, this standard deduction isn’t the best option for all taxpayers. There are several reasons why you may choose to itemize your deductions including significant medical expenses, charitable giving, interest deductions, and more.  These exceptions coupled with the sunsetting of the high standard deduction limits after the 2025 tax year warrant a closer look into the ins and outs of itemizing your taxes and the standard deduction.

Itemizing your deductions may be in your best interest if you are a high-income earner or have significant income and expense complexity for the preceding tax year.  In practice, itemizing deductions can be a complex and time-consuming process and is no longer the best option for many filers hence the introduction of the standard deduction.  However, itemizing deductions may save high earners and spenders a ton in taxes that the IRS would otherwise collect.  The most common three reasons someone may choose to itemize include high medical bills, significant mortgage interest, and high charitable giving.

The Big 3:

  • Medical Bills: While medical costs have skyrocketed across the country in no small part due to a broken insurance system (blog topic for another day) the IRS offers concessions to those struggling under a mountain of this debt. Any medical debt above 7.5% of your AGI (adjusted gross income) can be deducted from your taxable income.
  • Mortgage Interest Deduction: As home prices have skyrocketed so too have the mortgages required to purchase homes. Interest on the first $750,000 of mortgage debt can be deducted from your tax bill if you itemize in 2023.  You’ll get a Form 1098 from your mortgage servicing company at the start of the tax season.  Remember that this is likely to be more advantageous early in your mortgage when a more significant portion of your monthly mortgage payment is interest than later on in the loan.
  • Charitable Giving: Most taxpayers don’t keep track of their charitable giving because it is only deductible if you itemize your deductions. Thus 90% of filers will be ineligible to deduct it from their tax bill. However high rates of charitable giving or the use of a DAF or donor-advised fund allows you to bunch several years of charitable giving into one calendar year for tax purposes and get the deduction credit for your charitable endeavors.

This is not an exhaustive list of itemized deductions as you can also deduct state and local taxes, disaster losses, personal property taxes, and much more but in the interest of keeping this concise, I wanted to cover the heavy hitters.

So when would someone choose to itemize their taxes instead of filing the standard deduction?  Let’s look at an example where someone may choose to itemize their deductions and one where they might choose to itemize their deductions every couple of years.

Jim and Tony made $100,000 in 2023 and filed married filing jointly.  They had a scare with Tony’s health earlier this year and racked up $22,500 in medical bills while she was in the hospital.  Jim is a retired smoke jumper and donates to the Red Cross and other disaster relief programs; this year he made an $8,000 donation.  Lastly, they moved to Florida to escape the cold northern winters and paid $11,000 in mortgage interest on their new home.  Both Jim and Tony have good eyesight and are under 65 making them ineligible for those standard deduction increases.  They could file the standard deduction to reduce their taxable income by $27,700 from $100,000 to $72,300.

However, if they choose to itemize their deductions, they would get to deduct $15,000 for Tony’s Medical Expenses ($22,500-$7,500), Jim’s $8,000 donation to the Red Cross, and the $11,000 paid-in mortgage interest.  So, by itemizing their deductions, they would save $34,000 in taxable income and only pay tax on $66,000 of income for 2023.  After taxes that’s a savings of $756 in Federal Taxes for 2023.

While Jim and Tony reduced their tax bill by itemizing this isn’t always the case.  Had they not moved or Jim not donated to charity they would have been better off utilizing the standard deduction when filing their taxes in 2023.  However, itemizing can be part of a multi-year strategy utilizing DAFs and coordinating contributions with specific medical procedures.

From tax year 2022 through 2024 Burt and Ernie make $100,000 and file married filing jointly.  It’s important to them that they always donate $8,000 each year to a non-profit.  They have minimal mortgage interest to deduct and don’t have any medical expenses worth noting so they always choose to use the standard deduction.  Burt starts to get some knee pain and after some doctor visits realizes that he needs a knee replacement.  He plans the surgery for early 2022 at a total cost of $25,500.  Burt and Ernie could continue to file using the standard deduction for each of the years 2022-2024.

However, after reaching out to their financial advisor Burt and Ernie learned that because they have significant known medical expenses and they’re charitably inclined, they can “bunch” their deductions around one year to save more in taxes.  To do this they take the year that Burt is getting surgery and has significant medical costs (2022) and then fund a DAF or a donor-advised fund for three years in 2022.  This fund disburses money to the specified charity each year but allows Burt and Ernie to take the charitable deduction in the year it was funded.  So if they choose to fund it for three years ($8,000 x 3 years) with $24,000 and pay for Burt’s medical procedure they can deduct $42,000 against their taxes in 2022, then elect the standard deduction in 2023 and 2024.

As we delve into the intricacies of itemized deductions and the standard deduction, it becomes clear that the choice between the two isn’t one-size-fits-all. Each taxpayer’s financial situation is unique, and understanding how to leverage these deductions to your advantage can result in substantial tax savings.

For some, like Jim and Tony, itemizing deductions is the optimal strategy when they have significant medical expenses, charitable contributions, and mortgage interest to claim. In their case, itemizing deductions translated into tax savings, putting more money back in their pockets. However, it’s crucial to remember that this isn’t always the case, and for many, the standard deduction is the simpler and more advantageous route.

Moreover, financial advisors play a pivotal role in helping individuals and couples navigate the complexities of the tax code. They assess your financial situation, plan for multi-year strategies, and offer insights into when to itemize, when to take the standard deduction, or when to “bunch” deductions for maximum tax efficiency. As tax laws evolve and the high standard deduction’s future remains uncertain, seeking guidance from a knowledgeable advisor can be a wise choice to ensure you make the most of your tax-saving opportunities.

 

 

 

 

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