Have you ever heard someone say they aren’t going to pay their mortgage off early because they get to deduct their interest on their taxes? If you haven’t, then you may have heard someone say you can take charitable donations as an itemized deduction.
Chances are you have no clue what these people are talking about and how itemized deductions really work. That’s okay because taxes can be complicated. While you could save on your taxes with mortgage interest and charitable contributions, assuming you follow the rules, you might be surprised by how little you might be saving.
Luckily, just a couple minutes of reading will give you a better understanding of how itemized deductions really work. To top it off, you can avoid making bad financial decisions you may have made without your new knowledge.
Note: This article is not intended as tax advice for any particular situation. You should always contact your tax professional about your specific situation before making any tax decisions.
How Itemized Deductions Really Work
When you fill out your tax return, you have the choice of taking a standard deduction or itemized deductions. Sadly, you can’t take both. The standard deduction is a set number, based on your filing status, that most taxpayers can use on their tax return instead of using itemized deductions. For 2016, the standard deduction is $6,300 for single filers, $12,600 for married filing jointly filers and $9,300 for head of household filers. These amounts are important to keep in mind as you’ll soon see.
If you want, you can use itemized deductions instead of taking a standard deduction. Here are a few examples of itemized deductions for the tax year 2015 (2016 tax forms are not yet finalized):
• Medical and dental expenses in excess of a determined percentage of your adjusted gross income (AGI)
• State and local income taxes OR general sales taxes
• Real estate taxes
• Personal property taxes
• Home mortgage interest and points
• Mortgage insurance premiums, and
• Gifts to charity, etc.
For more itemized deductions, see Form 1040 Schedule A.
The first step is adding up all of your itemized deductions for a tax year. Check to see if your itemized deductions or standard deduction is larger. Then, in most cases, you’ll use the larger deduction when filing your taxes.
Examples – Why You Don’t Save As Much As You Think
In this first example, a married filing jointly couple calculates they have $14,000 in itemized deductions. People who don’t understand taxes would be excited that they don’t have to pay tax on $14,000 of their income because they itemized their deductions. In reality, itemizing deductions only increased their total deductions by $1,400 because they could have taken the $12,600 standard deduction instead. They’re spending $14,000 on itemized deductions and only getting a $1,400 tax benefit. Needless to say, if they’re only spending money on these items for the tax benefit, they’re majorly losing out.
It can get even worse. Let’s say a married filing jointly couple absolutely refuses to pay down their mortgage only because it is a tax deduction. In total, they have $9,000 in itemized deductions. In most cases, they’ll opt to take the standard deduction as it is $3,600 higher. Unfortunately, this couple receives no tax benefit at all from the mortgage interest and other itemized deductions.
The same goes for charitable contributions. Most people make these contributions for reasons other than the tax deduction. However, some people may give a little more because they think the contributions will save them money on their taxes. If they don’t already have itemized deductions in excess of their standard deduction, they won’t save on their taxes at all. They would have to give until their itemized deductions exceeded the standard deduction in order to start lowering the tax they owe. Then, they’ll only save on the amount over the standard deduction they qualify for.
Make Decisions Based On How Taxes Really Work
Now that you understand how itemized deductions work, you can make educated decisions on what to do with your money. If you take the standard deduction every year, you know that mortgage interest isn’t lowering your tax bill. If you usually end up itemizing your deductions, chances are charitable contributions may actually save you money on your taxes.
Just remember, each tax year is different. Tax laws change and so does your personal situation. Make sure you keep up to date with the latest rules so you can continue making educated decisions. If you don’t want to keep up with tax changes, you can always hire a professional to advise you.
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