Do you own a house with a mortgage on it? If so, you may be a good candidate to itemize your deductions on your tax return. Before we dive into why and how to do this, let’s first define what itemized deductions are, shall we? According to Wikipedia:
Under United States tax law, itemized deductions are eligible expenses that individual taxpayers can claim on federal income tax returns and which decrease their taxable income, and is claimable in place of a standard deduction, if available.
Let’s go over some of the most common items people can and do itemize. This list is the most common items. These include:
- Home mortgage interest paid on up to two homes. At the end of the year, you will receive a mortgage interest statement from your bank or mortgage lender, known as a 1098. This statement will list all the interest you paid on your mortgage.
- Property tax paid on that home(s). For the FP family, we receive our property tax statement from our County government in October, and have between November 1st-January 31st to pay it in full. For reasons I’ll discuss below, I suggest you don’t escrow property taxes and house insurance.
- State income taxes paid or sales taxes paid (9 states) based on an IRS provided sales tax table, but not both. If you live in a state with an income tax, which 41 states have, you are almost certain to have paid more income tax than sales tax.
- Charitable contributions, which can be made in the form of either cash donations (think Church) or property (think Goodwill).
Standard deduction vs. Itemized deductions
First, let’s discuss what a standard deduction is. It’s your 0% income tax bracket. That is, you don’t pay ANY Federal income tax on these amounts (Amen). You don’t need to do anything to qualify for this deduction. It’s defined by law. For 2016 returns,
Married couples $12,600 Online daters $6,300 (only jest, this is for single filers)
Simply put, if you add up all the allowable amounts for itemizing and they are greater than your standard deduction ($12,600 for FP), you can itemize your deductions. We itemized on our return for 2016. Itemizing gives you an even larger 0% income tax bracket. Let’s look at an example of when someone would itemize on their income tax return, shall we?
Property taxes paid $4,000 State Income taxes paid $3,000 Mortgage interest paid $6,000 Charitable contributions $600 Sum of itemized deductions $13,600
From the calculations above, we can see that the itemized deductions, $13,500, exceed the standard deduction, which is $12,600. If you are in the 25% federal tax bracket, you will save approximately $250 more ($1,000 multiplied by 25% =$250) than if you took only the standard deduction. We could just stop there, because that’s what the vast majority of tax filers do. They itemize if they can.
Are you average?
If you are reading this blog, you are striving for financial independence. By definition, you are anything but average. You are a skillful warrior, taking advantage of every trick of the trade, of every tool in your toolbox. You are shoveling money into a 401(k) and other tax advantaged vehicles that would fill a dump truck to the brim. Your retirement isn’t on cruise control. Rather, its in a high gear, racing to the early retirement finish line. The wind is at your back. Congratulations, now let’s save some more money by slightly tweaking our behavior.
If you are reading this blog, you are striving for financial independence. By definition, you are anything but average. You are a skillful warrior, taking advantage of every trick of the trade, every tool in your toolbox. You are shoveling money into a 401(k) and other tax advantaged vehicles that would fill a dump truck to the brim.
A case study of two similar taxpayers
I am going to show you the case of Jack and Jill, who are two very similar taxpayers, who take different tax strategies, and end up with different results.
Example 1- Jack
Jack is a married taxpayer, who owns a home with a mortgage on it. These are his itemized deductions:
Year 1 Year 2
Property Taxes 4000 4000
State Income Tax 3000 3000
Mortgage Interest 6000 5500
Charitable 500 500
Total deductions 13,500 13,000
Now let’s assume the standard deduction in year 1 is $12,600, resulting in a $900 additional itemized deduction.
$900 X 25% tax rate= $225 saved
In year 2, we will assume the standard deduction increased to $12,700, resulting in a $300 additional itemized deduction.
$300 X 25% tax rate= $75 saved
The total taxes saved over two years equals (225+75) $300. Needless to say, Jack is pretty happy he can itemize and save a bit of money.
Example 2- Jill
Jill is also a married taxpayer, who owns a home with a mortgage on it. She does things a bit differently than Jack, to maximize her standard and itemized deductions. The steps she takes to maximize her deductions are the following;
- She pays two year’s worth of property taxes in year 1. She does this by paying last year’s taxes in January, and the current year’s property taxes in November.
- She prepays her state income tax for year two, during year 1. For Jill, she can either do this by having higher state withholding allowances during the year out of her paycheck, or she can call her state tax bureau and ask them where to mail a check, to prepay the next year’s estimated taxes. In year 2 she fills out a form from her employer that withholds $0 state taxes from her check, since she already paid them in advance. Here is a sample withholding form from California.
- She pays her January mortgage payment, for year 2, in December of year 1. For year 1, she will have made a total of 13 payments. This extra payment is not a principal payment, and she informs her lender that it should be applied to the January payment.
- Jill gives some cash to her church, and regularly donates her used clothing and furniture items to Goodwill industries. Instead of doing this over two years, she makes $1000 of donations in year 1, and skips donating in year 2. Normally she budgets $500 each year for charitable purposes.
All of the above I mentioned are allowed by the IRA/tax law. Your tax return is calculated on a cash basis. That is, the deductions you take are based on when you made them, not when they were due. Now let’s look at Jill’s deductions:
Year 1 Year 2
Property Taxes 8,000 0
State Income Tax 6,000 0
Mortgage Interest 6,500 5,000
Charitable 1,000 0
Total deductions 21,500 5,000
As a taxpayer, you can deduct the HIGHER of your itemized deductions OR your standard deduction. While they took the same deductions over two years, resulting in $26,500 in total payments, Jill gets to deduct the following on her income tax return:
Year 1 Year 2
Itemized Deductions 21,500 0
Standard Deduction 0 12,700
Over two years, Jill has deducted $34,200 from her taxable income, vs. only $26,500 for Jack. Assuming all income is taxed at 25%, Jill has an additional $7,700 to deduct over two years.
$7,700 X 25% tax rate= $1,925 saved over two years.
Now let’s let that sink in for a moment. For a bit more effort, Jill has an additional $1,925 to invest, over two years, than Jack does. Compounded over future years, this money invested is large. Since Jill took the time to learn how to do this, she will be able to repeat this process again and again, resulting in even more savings and wealth building dollars to invest.
Let’s estimate the time Jill spent to itemize every other year.
- Read the Finance Patriot’s blog article a few times (2 hours)
- Made two property tax payments instead of one (0.5 hours)
- Called her mortgage lender to understand where to send an extra mortgage payment (1 hour)
- Called her state tax department, to understand how to properly prepay her state income taxes, and have $0 withheld in year 2 (2 hours).
- Made all her donations in year 1, instead of year 2 (0.5 hours, if that)
Total time spent= 6 hours
Total Taxes saved= $1925
Hourly rate for her effort= $321 per hour. (This is net, this money is not earned income and isn’t taxed. It is tax savings. It drops straight to the bottom line.) Better yet, when she does this the next time, in years 3-4, it will only take her half the time to do this. Hence, a future hourly rate of $624/hour. WOW. Better yet, she is a tax super ninja, and can now think of additional ways she can apply this strategy to save even more in taxes in the future years. She has gained more confidence in her abilities, and won’t hesitate to do so again.
In the world of early retirement, there are many ways to reduce your taxes, in order to save more money to invest. One of the most overlooked ways of minimizing your taxes is the concept of itemizing every other year. Although it will take a bit of effort, it will be well worth it. Also, this concept can be repeated again and again, reaping hundreds to thousands of dollars over the years.
Do you itemize your taxes? What tax tricks do you do to minimize your tax burden? Would you consider itemizing your taxes every other year?
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