On the Borderline? How to Qualify for More Tax Deductions

Unless you’ve been living under a rock, you’ve probably heard that tax reform is a thing right now. I have no comment on the clusterfuck that is the U.S. tax code and am not going to pontificate on rough drafts that are changing daily:

Yesterday: “The mortgage interest deduction will be repealed.”
Later Yesterday: “Never mind. We’re keeping the mortgage deduction. Now teachers can’t write off school supplies.”
Early Today: “Okay, another change here. Teachers can write off some school supplies, but now scholarships will be taxed.”

I will leave commentary on the implications of the proposed tax bills to this guy. In the meantime I will operate under the assumption that our elected officials in Washington D.C. will take longer than necessary to differentiate their heads from their asses and we’ll be paying taxes as usual through 2018. As it stands right now there are a whole lot of tax breaks of which people take advantage. These include a capped deduction on student loan interest, and write-offs for work supplies, charitable giving, mortgage interest and more.

Let’s Talk Taxes

For today, I’m going to keep the conversation above the line.

Okay, so there are two types of tax deductions. An above the line deduction is one that the IRS allows you to take to subtract from your gross income. What is your gross income? That’s what your income before ANY taxes are taken out. Get it?

Great! So on the IRS 1040 form everything on the first page up to line 37 leads up to calculating Adjusted Gross Income (i.e. your pre-tax income AFTER you’ve taken your allowed above the line deductions).

Lines 7 thru 22 add up all of your income sources, then lines 23 thru 37 calculate all of the expenses you can subtract from that income. These deductions include educator expenses (line 23), moving expenses (line 26), self employment stuff (lines 27-29), IRA contributions (line 32), student loan interest (line 33), and tuition and fees (line 34). The great thing about these above the line deductions is that anyone can take them regardless of whether you itemize or not.

Okay, let me back up. If there are above the line deductions, then logic dictates that there are below the line deductions. Below the line deductions are subtracted from Adjusted Gross Income and further reduce the amount of income you have to pay taxes on. Most people are entitled to either take a standard deduction of $6,300 for single filers, $9,300 for head of household filers, and $12,600 for joint or qualified widowed filers; OR they can itemize deductions like mortgage interest, charitable givings, state and local taxes, and healthcare expenses.

It only makes sense to itemize if you have deductions greater than the standard one the IRS gives.

At this time I’d say yes, unless you have a strong affinity for the color orange.

Above the line deductions are their own thing and give people who aren’t homeowners, major philanthropists, and large healthcare consumers a bit of a tax break.

There Is a Catch

Alas, not everyone can partake in all above the line fun. Many of these deductions are subject to income dictated limitations and phase outs. What does that mean? It means that although I’ve paid $1,755.24 in student loan interest in 2016, I could deduct not one red cent of it from my taxes.

Because my Adjusted Gross Income is too high. Student loan interest is deductible up to $2,500 a year, but only if your modified AGI is $65,000 or less. This deduction is then gradually reduced as your income increases over $65,000 until it is 100% phased at $80,000. That means if your AGI is $80K or more none of that beautiful student loan interest that you’re paying is tax deductible. Basically the IRS is saying you make enough money so…

Same thing for the IRA deduction. For those who do not know, an IRA is an Individual Retirement Account. There are a bunch of different types of IRAs but the two main ones people use most are the Traditional (pre-tax) and the Roth (post-tax). Total individual IRA contributions cannot exceed $5,500 for people under 50 years old, and $6,500 for individuals 50 or older. You can contribute to both a Traditional IRA and a Roth IRA in the same year but you can’t max both.

Before you get too disappointed I do have some good news. Uncle Sam does allow you to contribute to both an employer sponsored 401K and an IRA. And if you contribute to a traditional IRA those contributions just might could be tax deductible. However, once again there are income limits. For 2017, if you are also covered by a workplace retirement plan you can only deduct your full traditional IRA contributions if your modified AGI is less than $62,000 if you’re single or $99,000 if you’re filing jointly. This deduction then phases out between $62,000-$72,000 for single filers and $99,000-$119,000 for joint filers, and once you make $72K (or $119,000) or more you can no longer deduct traditional IRA contributions from your taxes.

On the Roth side there are also income limitations to contributing. For single filers contributions limits are gradually reduced after $118,000 and you’re ineligible at $133,000 modified AGI. For married couples and qualifying widows the income threshold for phase out starts at $186,000 and ends at $196,000, at which point filers are ineligible to contribute to a Roth.

Silver Linings Playbook

You may be reading this right now while looking at your $85,000 or $150,000 salary and cursing me for reminding you of all the ways you don’t get to save on taxes. However, I would never serve up bitter medicine without a spoonful of sugar. For those of you who are just missing out on Roth contribution eligibility or student loan deductions or any other income sensitive tax break there is a way to sneak in:

PRE-TAX CONTRIBUTIONS!!!

As Uncle Sam starts to tell you that you make too much money to need tax advantages (at least under previous administrations and tax plans), pre-tax contributions let you respond

These are the contributions you make to your 401K, pension plan, healthcare premiums, and more BEFORE any taxes are withheld from your check. This lowers the wages reported on your W-2 (which is the form that tells you the income to input on your 1040 form). So let’s say that your salary is $100,000 and you contribute 10% to your employer 401K and pay $100/month in healthcare premiums. Your W-2 will say that you earned $88,800 in income for the year.

Not bad. With those contributions alone you’re now in spitting distance of being eligible to write off at least a little bit of student loan interest.
Easy, you just use even more pre-tax savings.

Commuter Benefits

Do you pay transit or parking expenses to go to work? You and your employer can contribute up to $255/month for public transportation and $255/month for parking expenses in pre-tax dollars. Let’s imagine that you live in New York City and commute to work on the subway. You can buy your monthly unlimited Metrocard with pre-tax dollars. That’s $1398 off your income right there.

Flexible Spending Accounts

Do you get healthcare through your employer? If you do, then you probably have the option to contribute to a Flexible Spending Account. Basically, an FSA allows you to pay eligible medical expenses with pre-tax dollars that you’ve saved. For 2017 the IRS allowed people to contribute up $2,600/year to an FSA. The one caveat is that the funds are use it or lose it, meaning if you don’t spend your contributions on qualified expenses by the end of the year then you lose whatever is left in the account. Many employers offer the option to either carry over $500 from one calendar year to the next or give a two and a half month grace period after the plan year ends to incur eligible medical expenses (i.e. your plan year ends December 31, 2017, but you can use 2017 FSA funds to pay for a January 2018 medical expense). Let’s say you spend about $1000/year on healthcare. Setting aside that money in an FSA, just lowered your income another $1000.

Healthcare Spending Accounts

Another way to save on healthcare costs is with a Healthcare Spending Account. If you have a high deductible health plan then the government mandates that you have access to an HSA to save for healthcare expenses pre-tax. The difference between an HSA and FSA is that an HSA is your account to keep and you can pay for eligible expenses at any time. So if you contributed $1500 to an HSA in 2016 then racked up $2500 in medical bills, in 2017 you can contribute $2500 and reimburse yourself for the bills you paid the previous year. Also, if you don’t use your full year contribution it remains in the account to grow tax free. HSAs are awesome because they are a great way to save for healthcare expenses in retirement, especially if your healthcare costs are low now. Plus they’re triple tax advantaged. The Financial Panther blog goes into greater detail on the tax advantages of an HSA. For 2017 the max contribution is $3400 for individuals and $6750 for families. That’s a hefty chunk to withhold from the tax man.

Dependent Care Spending Accounts

Maybe you have ~~tax exemptions~~ children or are a caregiver to an adult relative. If you’re not like my parents you’re probably paying childcare costs for the under 12 crowd. You can also pay for that pre-tax with a Dependent Care FSA. Wanna put junior in summer camp? Does baby girl need to go to pre-school. Do you take care of an aging parent and wan to send them daycare? You can save up to $2500/year of that expense with pre-tax dollars. Here is a list of all of the care options that are eligible to be paid through a Dependent Care FSA. That’s another $2500 you’ve shaved off the top.

Workplace Sponsored Retirement Accounts

On top of all of these pre-tax savings, most people do not max out their 401K. Sure you contribute up to the company match maximum (i.e. employer matches contributions up to X% of your pay). However, in 2017 the IRS allows us to make up to $18,000/year in pre-tax contributions to qualified employer retirement plans. That is a lot of money to not pay taxes on.

Adding it Up

Going back to that $100,000 salary earner, by maxing out all available pre-tax savings a person can reduce their income to $70,440.
Now this taxpayer can deduct $1119 in student loan interest of the $1755 mentioned earlier, as well as an $860 contribution to a traditional IRA. These deductions further reduce AGI, which leads to lower taxable income and a smaller tax bill. And the cherry on top of this delicious sundae is that factoring in these additional deductions means less money needs to be withheld from your paycheck for taxes and you could bump up your take home pay a lotta bit by increasing the allowances on your W-4 (but only after running the numbers through the IRS calculator).

No Time Like the Present

Withholding nearly $30,000 in income via pre-tax savings vehicles is not realistic for many people. However, it’s a no brainer to at least use pre-tax dollars for eligible regular expenses you were gonna buy anyways, like commuter benefits and healthcare. It just so happens that if you’re not contributing to an FSA, HSA, or commuter benefits today may be your last shot to get on board.

Well for another 335 days, or until you have a major life event like birthing a baby or putting a ring on it. November is open enrollment month for 2018 benefits, including committing contributions to FSAs, Dependent Care FSAs, and HSAs.

Duly noted. I meant to post this earlier in the week, but what had happened was…so, ummm yeah…it is what it is. If you snoozed through open enrollment thus far at least you still have several hours to sign up and set up your contributions. Who knows, $1000 here, another $2000 there and all of a sudden your borderline “high” income can come down enough to get you a few more deductions.