Understanding Deductions

More precisely, federal Taxable Income is computed as noted in Exhibit 1.

Exhibit 1: Gross Income - Above-the-Line Deductions = Adjusted Gross Income

Below-the-Line Itemized Deductions or the Standard Deduction Amount (whichever of the two is the greater) - Personal and Dependency Exemptions = Taxable Income

The ultimate tax liability number is then determined by multiplying the applicable tax percentage rate against the Taxable Income number (we will look at computing the actual tax liability in just a moment).

NOTE that the base number on which federal income taxes is computed, Taxable Income, is reduced as we increase our deductions.  However, as noted in the Exhibit, there are two types of deductions: Above the-Line Deductions and Below-the-Line Itemized Deductions.  If you look at Exhibit 1, you will see that an Above-the-Line Deduction will always yield a tax benefit in that it will always reduce your Taxable Income number.  Above-the Line Deductions are generally business-related expenses.  For example, if you are a sole proprietor, the legitimate expenses of your proprietorship constitute Above-the-Line Deductions.  If you are not self-employed but rather work as an employee, Above-the-Line Deductions are rare because few personal expenditures are deductible Above-the-Line.  A few notable exceptions are the contributions to a traditional Individual Retirement Account (discussed under the Retirement Planning section), any alimony you might pay to your ex-spouse, and interest you pay on certain student loans (discussed later under Educational Savings).

By again referencing Exhibit 1, you see that the Below-the-Line Itemized Deductions may or may not yield a tax benefit in that they are only deductible to the extent they exceed the standard deduction amount.  In 2003, the general standard deduction amount was $4,750 for a single taxpayer, $7,000 for a single taxpayer who is the head of a household with dependents, and $7,950 for married taxpayers filing jointly.  Thus, if you are married, you and your spouse got no advantage from your Itemized Deductions in 2003 until all available Itemized Deductions for the year exceeded $7,950. The deduction for a personal or dependency exemption was $3,050 for the 2003 tax year.  The standard deduction and exemption amounts go up a little each year by a cost of living adjustment.  NOTE:  Throughout this book, I will primarily reference 2003 tax numbers.  This will allow you to compare the illustrated results with your own 2003 tax return.  Where particularly relevant, I will refer to 2004 tax law changes.

Example:  In 2003 Mark and Debbie have gross income of $125,000, make a $3,000 contribution to an Individual Retirement Account, have total Itemized Deductions of $20,000 and exhaustively attend the needs of their six dependent children.  Per the Exhibit 1 formula we would determine their Taxable Income as follows:

 

$125,000 (Gross Income) -  $3,000 (Above-the-Line Deduction to IRA) = $122,000 (Adjusted Gross Income)

$20,000 (the greater of their total Itemized Deductions for the year or their $7,950 standard deduction for married taxpayers) - $24,400 of Exemptions ($3,050 x 8 (2 jointly filing taxpayers and 6 dependents)) =  $77,600 (Taxable Income)

We will determine their ultimate tax liability on this amount of Taxable Income in the next  Example.

Since most of us are not self-employed and since the few personal expenses that are otherwise allowed as Above-the-Line Deductions cannot generally be counted on, the trick here is to expand the more reliable and predictable Below-the-Line Itemized Deductions to the point that they exceed the standard deduction amount.  The first step in our tax planning, therefore, is to make an itemizer out of you (if you are not already deducting your Itemized Deductions) or better optimize your Itemized Deductions (if you already are an itemizer).  But first you need to understand another fundamental concept.