Updated: Mar 3
-What is the standard deduction versus itemized deductions? -What are the common deductions people qualify for each year? -The reasons that you don't want to receive a tax return
-Having the extra money can be used to pay down debt or use for investments
It's time for the tax review.
Let’s do a quick check to see to understand what taxes come out of your paycheck:
Automatic deductions from everyone's paycheck:
-Social Security 6.2%
The social security income threshold for 2020 was $137,700 meaning if you made imcome over that amount during, the year there will no additonal tax taken from your paycheck.
The states with no income tax are Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming.
Should I Itemize or Take the Standard Deduction?
This is a pretty simple answer on which path to take. If your standard deduction is less than the total of your itemized deductions, then you should be able to save money.
Keep in mind that the cost for your tax and asset planning preparation may increase as itemizing requires more forms and maintenance to gather documentation. If you are using tax software, you may be covered.
If you are using a service, the time for the tax preparer will increase to process your documentation meaning time is money and you may pay a few more dollars.
On the other hand If your standard deduction is more than the total of your itemized deductions then this will be a better and much quicker option as the deduction is one calculation and it does not require paperwork.
If choosing to itemize there are many options available; however, it all depends on if you qualify.
There are several more than what we will highlight here as found on the IRS website:
https://www.irs.gov/taxtopics/tc501; however, here are some common ones:
Common Tax Deductions You Can Itemize
-$2,500 in student loan interest
-Investment interest expenses
-Medical and dental expenses (over 7.5% of AGI)
-$250 for educators buying classroom supplies and if and if expenses were incurred from March 12, 2020 that were not reimbursed this can be included related to COVID-19.
-Interest on mortgage of $750,000 or less
-Interest on mortgage of $1 million or less if incurred before Dec. 16, 2017
General Adjusted Gross Income Example
You can get a basic understanding to put yourself in the ballpark of the taxes that you may owe by using the tax tables and a few deductions.
According to the Tax Foundation (this link is updated to the current calendar year) they estimate about 13.7 percent of taxpayers will itemize in 2019. So this means this high majority of Americans will file taxes using the standard deduction.
The Standard Deductions
Subtract single or married deduction are listed below:
You may also qualify for child tax credits which are refundable up to $1,400 but there are a number of factors required to qualify; however, many people do. There is also a phase out of the credit even if you qualify based on your income.
Phase out: if $400,000 for married filing jointly and $200,000 for everybody else.
Now let’s estimate your adjusted gross income and we love tax deferred accounts. These accounts are deducted from income as we’ve talked about in Podcast #45, The 401(k) and the Roth 401(k) Review.
Using Federal Tax tables to Estimate Tax
For example: You earned $80K gross Income and you had $12,000 in 401(k) invested and one child. So this means that you have a deduction for as a single person of $12,400.
So the basic math is 80K - 12K for 401(k) and 12,400 for deduction. So the AGI would be $55,600. From there you can use a tax table.
Federal tax is $4,617.
$55,600 - $40,125 = $15,475 >> $15,475 x .22 = $3,404.
So the tax would be $4,617 + $3,404 = $8,021.
As for the state tax, if it applies to you then you take your AGI and multiply it by the state tax rate to see how much money that you need to pay out to the government. For example, in Michigan if our AGI is $100,000 and the tax rate is at 4.25% we’d owe $4,250.
Keep in mind that we are not CPA’s so you need to do your own homework; however, what we’ve just described here should put you in the ballpark.
A good way to get a handle on this is to speak to your CPA or tax preparer to map out your next year’s income and deductions so that you can prepare.
You Don’t Want a Tax Return
We talked about in Podcast #15 How Income Tax Can Either Add to Your Debt or Increase Retirement; however, we are going to cover this again. This is one of the most hidden pieces to personal finance the people do not account for that can save money by paying down debt or increasing investments.
Everyone should think about this. When receiving a tax return, you’re just lending the government your money. So why not have that money in your budget month?
According to IRS.gov the average tax return in 2019 was $2,869. So let’s round this to $3,000.
So let’s do a debt example. Suppose Lucy J. has $10,000 in credit card debt and is making the minimum payment 3% with a 12.99% interest rate. To pay this off it would take 42 months with $2,472 in total interest paid and overall the total payments calculated to $12,472.
Now if we round up the average return to $3,000 and divide that by 12 months that equals $250. So if we tacked that additional payment to the minimum payment that comes to $550 per month. So this is awesome!
The total time to pay the card off is 21 months with $1,197 in total interest paid with a grand total of $11,197. So when comparing the two scenarios $1,275 was saved and the payoff time is cut in half.
Let’s say that you carried that out for 10 years, that would come to $44,350 and for 30 years, $303,219. This is really simple once you think about it.
It’s Time for the Recap
When it comes to your taxes, If your standard deduction is less than the total of your itemized deductions should be able to save money.
You need to keep good records of your documents especially if you itemize. This means that you will need more forms to complete and it may lead to a higher cost file your taxes.
Always do your own homework and research based on your situation. The more that you know about your personal finances, the more possibilities exist to pay less tax to Uncle Sam. Also, consider hiring a certified public accountant or CPA as he/she can be accessible at any time during the year.
We advise that you should seek to balance your finances so that you attempt to have a small tax return or owe a small amount to the government. Take your average tax return from previous years and use it as a guide to understand how much money you’d have on a monthly basis rather than waiting on it once a year.
Next, take that money and pay down interest bearing debt such as credit cards and car payments or if your debt-to-income is managed well, you can take that money and invest it so that the compound interest can do its magic.