We hear about all kinds of tax deductions: mortgage interest, charitable donations, and even state and local tax deductions. Every year, Americans dutifully keep records of tax-deductible items in order to get some relief from Uncle Sam at tax time. Some even make decisions — such as taking on a larger mortgage loan — because of the allure of specific tax deductions. This is decidedly bad for one’s financial health. In many instances, these decisions do not pay off: most taxpayers receive a greater benefit from taking the standard deduction over itemizing their deductions.
But let’s be perfectly clear up front — not all potential deductions fall under the itemized deductions category. Some deductions, such as student loan interest, moving expenses, and the first $250 of unreimbursed teacher expenses, are deductible regardless of whether you itemize or take a standard deduction. These are technically “adjustments to income” and found on the first page of your 1040 form.
Who benefits from itemized deductions?
Approximately one-third of taxpayers file tax returns with itemized deductions, according to the Congressional Budget Office. People with higher incomes tend to be the ones who itemize their deductions, as taxpayers in higher tax brackets disproportionately benefit from itemized deductions. For instance, over 50% of the total tax benefits go to taxpayers whose earnings are in the top 20%; a full 17% of the total tax benefit goes to taxpayers whose earnings are in the top 1%!
Why do high-income earners disproportionately benefit from itemized tax deductions?
Income tax is calculated by multiplying the tax rate of a tax bracket by the taxable income in that that bracket. Deductions reduce taxable income, which in turn reduces the amount of taxes you have to pay.
Our tax system is progressive — meaning that income in higher tax brackets is taxed at a higher rate than income in lower tax brackets. As a result, high-income individuals get more benefits from an income deduction because their tax rate is higher on the last dollar of their income.
An example:
Al earns $50,000 a year, and the last $10,000 of his income is taxed at a rate of 10% (marginal tax rate). If he is able to deduct $10,000 from his income due to the mortgage interest deduction, he would save $10,000 * 10% = $1,000.
Betty earns $150,000 a year, and the last $10,000 of her income is taxed at a rate of 40%. If she is able to deduct $10,000 from her income due to the mortgage interest deduction, she would save $10,000 * 40% = $4,000.
Although Al and Betty paid an equivalent amount in mortgage interest and both were able to deduct an equivalent amount of $10,000 from their incomes, Betty’s benefit was four times greater than Al’s because her marginal income was taxed at a higher rate.
Why don’t more taxpayers itemize their deductions?
Each taxpayer must elect to either itemize deductions or take the standard deduction. If your standard deduction exceeds your itemized deductions, you should take the standard deduction. For the 2013 tax year, the standard deduction is $6,100 for an individual and $12,200 for a married couple filing jointly. The standard deduction often exceeds the value of itemized deductions that the average taxpayer accrues during the year, so most taxpayers don’t actually benefit from itemizing deductions.
Conclusion:
Itemized deductions can offer significant tax benefits — but only when the taxpayer itemizes his or her deductions, which typically only makes sense for higher-income earners. In other words, in many instances, itemized tax deductions don’t actually translate into actual tax savings! Making financial decisions based on a gut-level expectation of an itemized tax deduction may be very bad for your financial health.
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