"I've been reading that with the higher standard deduction amounts, fewer people will benefit from itemized deductions than in the past. But what about deductible IRA contributions? Does that mean most people should make Roth IRA contributions instead?"
That question crossed my desk shortly after the passage of the new tax laws, and it underscores that there's understandable confusion about the various deductions you can take on your tax return. A deduction is a deduction is a deduction, right?
Actually, no. Higher standard deduction amounts going into effect starting with the 2018 tax year are likely to make itemizing deductions much less profitable for many taxpayers than was the case in the past, because taxpayers can use the higher of their standard deduction or their itemized deduction. At the same time, many so-called above-the-line deductions aren't changing a bit. Above the line refers to the deductible items found in the Adjusted Gross Income section on the first page of the 1040 form; these deductions reduce the adjusted gross income that gets reported on Line 37 of the 1040 return. (Adjusted gross income is effectively "the line.')
That means that regardless of whether they itemize their deductions or claim a standard deduction, taxpayers will still be able to deduct above-the-line outlays like their IRA contributions (assuming their income falls under the thresholds here). IRA contributions and contributions to SIMPLE and SEP IRAs are also deductible because they're above the line. In a similar vein, taxpayers will still be able to deduct their health savings account contributions if they're covered by a health savings account, as well as qualifying student loan interest, among other items. True, there are some tweaks to what's deductible above the line starting with the 2018 tax year, but much is staying the same.
On the flip side, so-called below-the-line deductions--the ones you itemize and include on Schedule A along with your tax return--are the deductions that are apt to be less beneficial for many households than was the case in the past, owing to the new higher standard deduction amounts. With taxpayers allowed to take the greater of their standard deduction or itemized deductions, the standard deduction is likely to win out even more frequently than it does today. Below-the-line deductions include items like charitable contributions, qualified medical expenses, and mortgage interest. To preserve their ability to benefit from those below-the-line deductions, at least periodically, taxpayers will need to strategize about when they incur expenses that are deductible below the line, and when they use the standard deduction versus itemizing their deductions.
Above the Line: (Almost the) Same as It Ever Was
A look at the 1040 form can help you visualize where the terms "above the line" and "below the line" come from, and just why those above-the-line deductions are so important. On the 2017 form, lines 23 through 35 depict various tax-deductible outlays, including IRA and HSA contributions, SEP and SIMPLE IRA contributions, and health insurance paid by self-employed folks. If you're employed and taking advantage of analogous benefits offered by your employer, outlays are automatically deducted from the wages you report on Line 7 in the Income section toward the top of the 1040 form. But if you're self-employed you need to account for them through these deductions.
Note that a handful of above-the-line expenses are changing beginning in 2018. Alimony will no longer be deductible by the person making payments, as Karen Wallace discusses here; nor will moving expenses for a job change, unless you're an active member of the military. Student loan interest and educators' out-of-pocket outlays for their classrooms (up to $250) were originally on the chopping block as part of the tax debate in Washington, but remain as above-the-line deductions for now.
Taking advantage of these deductions helps reduce the amount of adjusted gross income that's reported on Line 37 of your tax return. And by lowering AGI (and its relative, modified adjusted gross income), you improve the odds that you'll be eligible for credits on Page 2 of your 1040, such as the Retirement Contribution Credit (Saver's Credit) and Child Tax Credit. Your modified adjusted gross income also determines whether you're eligible to make a deductible IRA or Roth IRA contribution. Your eligibility for certain itemized deductions, such as the deductions for medical and dental expenses and charitable contributions, also depends on the percentage of your adjusted gross income that these outlays account for. For all these reasons, tax experts view AGI as "the big number" on your tax return, much more important than the income you report on Line 7 of your return. That was true before the new tax laws went into effect and it's still true now.
But Look Out Below
On the other hand, the new tax laws have significant implications for the below-the-line deductions--the one that you itemize on Schedule A. Thanks to the higher standard deduction amounts going into effect next year, as well as some adjustments to the itemized deductions themselves, those deductions will be much less valuable for many taxpayers.
For the 2018 tax year, the standard deduction amounts will be increasing to $12,000 for individuals and $24,000 for married couples filing jointly. Personal exemptions are going away, but those new higher standard deduction amounts still represent a giant increase over the 2017 standard deduction amounts of $6,350 for individual taxpayers and $12,700 for joint filers. Those higher standard deduction amounts will likely lead to a reduction in the number of taxpayers who itemize their deductions rather than claiming a standard deduction.
Moreover, the thresholds affecting the deductibility of various outlays are changing. In a handful of instances they’re getting more generous: For both 2017 and 2018, for example, medical expenses are deductible to the extent that they exceed 7.5% of adjusted gross income. Previously, that floor was 10% of adjusted gross income for taxpayers under age 65. (The "floor" for deductible medical expenses will go back up to 10% starting with the 2019 tax year.) In a similar vein, charitable contributions of cash of up to 60% of adjusted gross income are deductible starting in 2018; prior to the new tax laws taking effect, that threshold was 50% of AGI. (Of course, it's a rare taxpayer who's contributing 50% of his or her income to charity; the 60% of AGI limit will generally only apply to very wealthy, very charitably inclined people.)
On the flip side, Congress tightened up the deductibility of other items. Notably, the deduction for state and local taxes, including property taxes, is now capped at $10,000, causing angst in residents of high-tax states. In addition, the new tax laws put a cap on the deductibility of interest for new mortgages that exceed $750,000. (For properties purchased prior to Dec. 15, 2017, interest on mortgages of up to $1 million is tax-deductible on Schedule A.) In addition, home equity loan interest will only be deductible if the loan is used to finance home improvements, not new car purchases or even basic home maintenance.
What Should You Do?
That combination of higher standard deductions, as well as limits on some of the big-ticket deductions many taxpayers had been able to use in the past, mean that those below-the line deductions reported on Schedule A will be less beneficial for many taxpayers.
But those deductions aren't necessarily a lost cause. As Baird director of advanced planning Tim Steffen discusses in this video, the idea of "bunching deductions" such as medical expenses into a single year to take advantage of itemization has always been attractive, but the new tax laws make it even more so. Similarly, taxpayers might bundle together charitable contributions into a single large donation rather than making smaller contributions on a year-by-year basis. (A donor-advised fund is ideal in this situation, enabling the donor to take advantage of the complete deduction for the donation but also providing time to donate the money to charity.) Such strategies enable a taxpayer to claim the standard deduction in most years but itemize in a handful of others. As the 2018 tax year gets under way, it's a great time to check in with your tax advisor for guidance on whether such strategies might make sense in your situation.