Itemized deductions: a beginner’s guide

There’s a scene in Arrested Development where the overly business-centric father, Michael, gifts his nerdy teenage son George Michael a copy of Quicken. 

“Wow, Quicken, thanks dad… did you keep the receipt?”

“You don’t like it?”

“No! I want to deduct it!” 

As a kid, I always laughed at this joke even though I had no idea what it meant. 

Now, I totally get it. 

Deducting stuff from your taxes is honestly pretty satisfying. Whether it’s the standard deduction amount or you go the itemized route, either will slash your bill to Uncle Sam. 

But how does itemizing deductions work? What’s the difference between “standard” and “itemized” deductions? Why did George Michael need the receipt? 

What are tax deductions?

Imagine you made $60,000 in 2021. 

That puts you in the third tax bracket (find your bracket here), meaning your federal income tax will be around $9,000. 

So the IRS says to you “since you put exactly $60,000 in the bank this year, you owe us $9,000.”

You might say “well, hang on – I didn’t exactly put precisely $60k in the bank last year – I had expenses, you know.” 

“Well, how much did you end up putting in the bank in 2021?”

“Honestly? After rent, utilities, student loans, car payments, tacos… I probably only netted like $14k.”

The IRS noodles on that for a bit, then responds: 

“Well, if we only taxed you and everyone else on their net earnings, we wouldn’t have enough money for roads and social security and stuff. Plus, people who blew all their money, accidentally or on purpose, wouldn’t have to pay taxes.” 

It’s a fair point. 

So you find some middle ground. 

The IRS concedes that since everyone has expenses, it wouldn’t be right to tax 100% of your income. 

This idea gave rise to deductions. 

Standard tax deductions

Each year, the IRS comes up with a flat dollar amount that they agree not to tax you on. 

This amount is called the standard deduction. 

Your adjusted gross income (AGI) minus your deductions = your taxable income. 

Anyways, for the tax year 2021 (aka the taxes you file in April, 2022), the standard deductions are as follows, based on your filing status: 

• $12,550 for single filers and married filing separately,
• $26,900 for joint filers, and
• $19,400 for head of household.

So if you make $60,000, and you choose the standard deduction amount of $12,550, your taxable income is only $47,450. 

When you choose the standard deduction, the IRS doesn’t ask any further questions. Even if you live rent-free and really did put $60k in the bank last year, you still qualify for the standard deduction. 

Read more: 10 Deductions You Didn’t Know You Could Take As A Business Owner

But what if it’s the opposite? What if your expenses go way beyond the standard deduction? 

Then you might consider an itemized deduction. 

What are itemized deductions?

Itemized deductions are when you say to the IRS:

“Hey, I had some major expenses this year, so my taxable income should be much lower.” 

“Alrighty, fair enough.” says the IRS. “Here’s the deal: we’ll let you deduct some expenses and not others from your taxable income.”

Basically, you can’t include rent and tacos in itemized deductions. The IRS only accepts a few types of expenses as itemized, and the list is growing shorter – which is why most folks tend to accept the standard deduction. 

Itemizing your deductions only makes sense if the value of your itemized deductions exceeds the standard deduction.

So what kinds of expenses would the IRS accept as an itemized deduction from AGI? 

Types of itemized deductions

For a quick glimpse at the kinds of expenses the IRS accepts as itemized, you can check out the actual form: IRS Schedule A of Form 1040. 

Here’s a TL;DR: 

• (Unreimbursed) medical and dental expenses, now including COVID-related PPE purchases and driving mileage.
• State and local taxes (income, sales, real estate, personal property).
• Mortgage interest and insurance premiums.
• Student loan interest.
• Investment interest and bond premiums.
• Charity, including a charitable donation to a verified tax-exempt organization, non-cash donations, and even mileage and other expenses related to volunteer events.
• Casualty, theft, and disaster losses.
• Gambling losses.
• Impairment-related work expenses for the disabled.

It’s worth pointing out, too, that not all expenses within these categories will be deductible. For example, life insurance premiums aren’t deductible, nor are mandatory state contributions to unemployment funds. 

Plus, you’ll need records of everything you itemize – receipts, statements, etc. That’s why George Michael asked his dad for a receipt for Quicken!

Read more: Need A Tax Break? Here’s A List

Here’s why most people take the standard deduction

As you’ve probably surmised, itemizing your deductions can be a little complicated – and the list of things you can itemize isn’t that long. 

Even still, back in 2018, a whopping 46.2 million American taxpayers opted to itemize their tax deductions for the 2017 tax year.

But for the 2018 tax year, that number plummeted to just 16.7 million.

What happened? 

2018 was the year the Tax Cuts and Jobs Act went into effect which dealt a one-two punch to itemized deductions: 

1. It roughly doubled the standard deduction from ~$6,000 to ~$12,000 for single filers.
2. It eliminated personal exemptions and reduced the number of qualifying itemized deductions.

The IRS clearly wanted more people to take the standard deduction, but that doesn’t mean it’s right for everyone. 

How to itemize your deductions

In order to itemize your tax deductions, you’ll need to:

1. Identify your allowable itemized deductions using this IRS publication: 2021 Instructions for Schedule A.
2. Ensure you have records and receipts for each of your deductions.
3. Calculate your itemized deductions and enter them on IRS Schedule A of Form 1040.

Now, a good tax software can help you with all three steps.

Typically how it works is the software will automatically try and determine which deduction – standard or itemized – is right for you by asking some simple questions. 

The process for entering itemized deductions is never short – but it can be simple with the right tools. 

We’re fans of Intuit TurboTax, but for some additional options that we recommend, check out Best Tax Software: Compare TurboTax, H&R Block, TaxSlayer, E-File, TaxAct, Credit Karma Tax, And Liberty Tax. 

Pros and cons of itemized deductions

Pros to itemized deductions: 

• You could save hundreds, even thousands on your taxes. If your itemized deductions exceed your standard deduction for the tax year 2021, you could save lots of money on your taxes.
• You can save after making a big charitable contribution. If you made a considerable donation to charity in 2021 you could get a big kickback on your taxes – positive karma at work.
• It brings relief to those with significant interest or medical debt. If you’re suffering under the weight of high medical debt or property/student loan interest, itemizing your deductions may relieve some of your financial burden.
• Tax software makes it easier than ever. A solid tax program can automatically help you identify if itemizing is right for you, and if so, walk you through everything you need, step-by-step. 

Cons to itemized deductions: 

• There’s still significantly more work involved. Even with a good tax software, properly filing your itemized deductions can take plenty of accounting, paperwork, and digging up old receipts. You’ll also need to keep those receipts in a safe place in case you’re audited by the IRS about your deductions.
• There are tons of restrictions to track. You can only deduct up to $10,000 worth of state and local taxes. Medical expenses must exceed 7.5% AGI. Mileage reimbursement for medical reasons is $0.16/mile, but only $0.14/mile for charity and volunteering. These are just three examples of the hundreds listed by the IRS, which is why working with a CPA or a good tax software is strongly recommended.
• You may end up with a smaller deduction. You may go through all the rigamarole of preparing your itemized deduction only to discover that your total amount falls short of the $12,550 standard deduction. Oh, well. At least you’ll sleep well knowing you didn’t leave money on the table.
• Tax software may charge more for itemized deductions. Your preferred tax software may upcharge you for helping you fill out Schedule A Form 1040. If you’re dead set on itemizing your deduction, try to hunt down this fee, since it could make the overall cost close to working with an actual CPA (or wipe out your tax savings from itemizing). 

When to itemize vs. take the standard deduction

Since the Tax Cuts and Jobs Act, the number of American taxpayers taking the standard deduction has risen from roughly 68% to 90%. 

It’s not just because it’s wayyy more convenient – it’s also because most Americans don’t have $12,550 of itemized deductions. 

That being said, maybe you’re the 1 in 10. 

Speaking bluntly, old rich people often itemize their deductions because they pay so much in state and local property taxes. 

But if you’re under 30 and still working towards financial independence, the two most common reasons I can think of for itemizing your deductions are if you had high medical bills and interest payments. 

Take a second to consider how much you spent in the categories you can itemize. If it’s anywhere near $12,550, you’d probably know right away. 

If it’s only a few grand, the standard deduction will save you the most money. 

FAQs about itemized deductions

How are tax credits different from tax deductions? 

Tax credits are a direct, dollar-for-dollar reduction of your tax liability. In other words, a discount on your tax bill. 

So if you got a federal tax credit of $7,500 for buying an EV in 2021, and your taxes are $9,000, you’ll only pay $1,500 in taxes. 

Tax deductions reduce your taxable income. So if you got a $7,500 deduction, that just reduces the amount of money you made in the IRS’s eyes by $7,500. A tax deduction of that amount might reduce your taxes by roughly $1,600. 

Read more: Understanding The Differences Among Tax Credits, Deductions, And Adjustments

Do I need to send receipts with my itemized tax deduction? 

The IRS may ask you to submit additional forms or records for certain deductions, like Form 1098 from your mortgage lender to deduct your mortgage interest. 

But generally speaking, you don’t have to submit sales receipts to the IRS. You are required, however, to keep electronic records of everything you deduct – receipts, bills, etc. since the IRS may come asking for them. 

What if I’m missing a receipt? Should I still enter my deduction? 

This is coming from a fellow taxpayer – not a CPA – but it’s probably not worth it. You don’t wanna mess with tax law – that’s how the IRS got Al Capone. 

If you submit a deduction without an electronic record on standby to back it up, an audit could result in the IRS disallowing the deduction and fining you. 

If your estimated itemized deductions are close to the standard deduction – but you’re missing lots of receipts and records – it’s probably better to just take the standard deduction this year and keep better records next year. 

Summary

Despite the Tax Cuts and Jobs Act making the standard deduction much more appealing, 1 in 10 Americans still file for itemized deductions.

Itemized deductions might make sense if your medical bills, interest payments, and state/local taxes exceed $12,550. Keep in mind, though, that there’s lots of paperwork and record-keeping involved to do it right!

Featured Image: ymgerman/Shutterstock.com

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