The longer I do this, the more I realize how important reiterating the basics of finance is. Interacting with regular readers on the forum and the comments section, it's easy to think that most of my readers are hyper-sophisticated financial gurus interested in relatively minor points of investing and finance. But when I go out and meet doctors who have never heard of WCI, it becomes obvious that just repeating the basics over and over again will do far more good. They don't want to know the intricacies of non-recognition vs recognition policies, they just need to hear “Whole Life Insurance…Bad.” Along that vein, I thought today would be a great opportunity to take a careful look at Schedule A.
A personal finance guru who hears the words “Schedule A” immediately knows we're talking about itemized deductions, but I bet there is plenty more for the rest of us to learn from a post like this. Tax literacy is particularly low among physicians. I often run into people, online and in real life, who think if they could just find the right “tax guy” that they would pay dramatically less in taxes. In reality, while a good accountant can be useful in a complicated business or real estate situation, they are likely to only make minor changes around the edges. Real reduction of your tax bill comes from living your life differently. The big changes come from getting married, having kids, maxing out retirement accounts, generating more income, changing your business structure, buying a house, moving to a different state, or giving money away to charity. We'll be talking about some of those items today, as they get reported on Schedule A.
All Tax Deductions Are Not All Equal
Before we get into the nitty-gritty, let's recognize an important point- all deductions are not equal. In fact, there are really three types. The first is a business expense, which comes off before you even enter your gross income on your 1040. Those are the best deductions, since you don't even have to pay payroll taxes on those. The second is an “above-the-line” deduction (the line is Line 38 of the 1040-your adjusted gross income,) such as retirement plan contributions, the self-employed health insurance deduction, and the student loan interest deduction. The third type, a “below-the-line” deduction, is what goes on Schedule A. While better than a kick in the teeth, Schedule A deductions are not nearly as good as the other types.
Itemized vs Standard Tax Deduction
Schedule A contains all of your “itemized” deductions, including medical expenses, charitable donations, taxes, and mortgage interest. Most people know that they need to add up their itemized deductions and then decide whether to take the standard deduction or, if your itemized deductions are larger, the itemized deduction.
The standard deductions in 2016 are:
- Single- $6,300
- Married Filing Jointly- $12,600
- Married Filing Single- $6,300
- Head of Household- $9,300
- Surviving Spouse- $12,600
In reality, that's an incredibly easy decision and your tax software will typically take care of that for you. But the point is, if your itemized deductions aren't going to be anywhere near the standard deduction, you don't have to bother with Schedule A at all. I don't do a Schedule A for my kids, for instance. But the subtleties come in when you realize that stuff that you thought was completely deductible, is really only partially deductible. For example, if you're married filing jointly, and the total of your itemized deductions is $15,000, then yes, you should itemize, but no, your mortgage interest really isn't fully deductible. Only the portion above $12,600 is. That affects many people at the lower income end, although a few people can get around it by “bunching” itemized deductions, taking the standard deduction every other year.
At the other end of the income spectrum is the Pease phaseouts. At an adjusted gross income (line 37) of $259,400 (single) or $311,300 (MFJ), your itemized deductions start getting phased out. Basically your itemized deductions are reduced by 3% of the amount of AGI above the threshhold. So if your AGI is $500K and you're MFJ and you have $50K in itemized deductions, then your actual deduction is $50,000-($500,000-$311,300)*3%= $44,342. You never lose more than 80% of your itemized deductions however. In reality, for most of us in this income range, this is just a disguise of a higher marginal tax rate. It basically increases your marginal tax rate by 1.18% but it shouldn't cause you to reduce your itemized deductions (unless you can change them to business deductions) since it is really more predicated on your AGI, not your deduction total.
Itemized, below-the-line deductions also have no effect on anything that is predicated on your AGI. This includes Roth IRA direct contribution eligibility and traditional IRA deduction eligibility. That's because the bottom line on Schedule A feeds directly into Line 40 on your 1040, below Line 37/38- your AGI.
Schedule A, Line by Line
Let's take a look at Schedule A.
Medical Expenses – Lines 1-4
The first section is all about your medical expenses. However, you can almost certainly skip right over this, and I'll tell you why. First, consider a typical physician income. Even if you're a good saver, you've probably got an AGI of $150-200K. So 10% of that is $15-20K. And the maximum out of pocket for most insurance plans is less than that. So the chances of you spending enough on health care in a single year to actually get a deduction here is pretty low. Even if you did get one, it probably wouldn't be very big, especially if you consider that anything spent out of your health savings account doesn't count.
Taxes – Lines 5-9
In this section, you get to deduct either your state and local income taxes or your sales taxes. As a physician, you're almost always going to be better off deducting your income taxes instead of sales taxes, unless you live in a state with no income tax (or are in the military.) If you do live in a no income tax state, then might as well take the sales tax deduction. There are two choices there, you can either add up all the sales tax you've paid or just take an IRS estimate of it. No way am I going to add up all my sales tax on my own, so when I've taken this deduction, I just took the IRS estimate. Maybe if you had some really big purchases in the year (like a wakeboat) it might make sense to try to add up all your sales tax, but man, I think it's a pain to keep track of mileage. I can't imagine trying to keep track of all the sales tax I paid in a year. Besides, the chances of me spending as much as the average guy with my income seems very low to me, so it would be strange for someone like me to not be better off with the IRS estimate/tables. At any rate, even in a year with some big purchases, you're still not going to get anywhere near what you're paying for state taxes. I mean, the Utah table pretty much maxes out at $2,454 and I'm paying 10 times that in state income taxes.
You also get to deduct any property taxes (Line 7) paid on your primary and any secondary homes and can deduct “other taxes” like foreign taxes paid. (generally don't, since you should take the foreign tax credit instead on line 8.)
Mortgage Interest- Lines 10-15
Here is where you get all that tax benefit from having a mortgage. It's pretty straightforward for most us. Take the amount in Box 1 on your 1098 from your lender, and put it on line 10. If you are paying PMI, it goes on Line 13 (and comes from Box 5 on your 1098.) Then ask yourself why you're paying PMI when you could have gotten a doctor mortgage without it. Remember only the interest on the first $100K of a home equity line of credit is deductible unless you spent it on improving the house.
Charity- Lines 16-19
Pay tithing? Now's your chance to reap the rewards. Cash goes on line 16 (make sure you have documentation of anything over $250 in case of an audit. Stuff you gave to Goodwill goes on Line 17. So does any charitable miles. So if you've been driving Boy Scouts all over tarnation, keep a record and get a few bucks off your taxes. Don't expect much though, it's only 10 cents a mile, so maybe 3-4 cents off your taxes per mile. You're spending way more than that on gas. Which brings up a good point. Many doctors ask me, “What can I do to lower my taxes,” at which point I list off the various deductions such as taxes, mortgage interest, and charitable contributions. They reply, “But those cost me more than the tax benefit, don't they?” Of course they do. If your goal is to have more after-tax money available to you, then giving it to charity (or a lender, or the government) isn't going to help. You're paying a dollar to get 30 or 40 cents back. But if you're doing these things anyway, you might as well get the deductions.
The Other Stuff- Lines 20-28
For most of us, you really only have to pay attention to lines 5-19. But it's possible, even if unlikely, that you could get a deduction after line 19. It seems like there would be something there you could use, but in reality, like medical expenses, it almost never works out for a physician due to the 2% of AGI “floor.” That is to say, only the amount greater than 2% of your AGI (perhaps $4K for a physician) is actually deductible.
Line 20, casualty or theft losses, isn't actually subject to the 2% floor. So if you had something really expensive stolen or ruined by natural disaster, be sure to claim that. But here's the catch, you can't deduct the loss of anything worth less than $100 OR losses that total less than 10% of AGI. Anything worth more than 10% of your AGI probably ought to have insurance on it, so don't count on ever getting anything from this deduction.
Line 21 is all about the work expenses your employer didn't pay for, like white coats, CME, your license, scrubs, and stethoscopes. Unfortunately, it's all subject to the 2% floor, so you probably won't get much of a deduction if any. One good reason to have at least a little 1099 income!
Line 22 is where you put your accountant's fees or what you paid for Turbotax. Again, with the 2% floor, you're probably not going to get much of a deduction. Maybe if you have a really expensive tax return, bought some really nice scrubs and took a really expensive CME trip.
Line 23 is where you put your investment expenses. Finally! Something you may be able to deduct, at least if you pay a financial advisor big AUM fees to do your investment management. Most of us DIYers aren't going to get much of a deduction here though. [Update 8/26- This DOES NOT include mutual fund expense ratios since your returns/income/gains/losses are all net the ER already.] If you pay your taxes by credit card, include the fees here. (No, you don't have to reduce them by the amount you earned as credit card rewards.) By the way, if you are paying AUM fees, try to get your advisor to take them out of your tax-deferred accounts- then you can pay them with pre-tax dollars. Way better than a Line 23 deduction.
Line 28 is where you put your gambling losses. At least they're not subject to the 2% floor. There are a few other losses you probably don't have that can go on this line.
Dumping Your Whole Life Policy
Some people who dump their whole life policy exchange it to a VA if it has a loss in order to preserve that loss to help on their taxes. They can either wait until the investment in the VA grows back to their basis, then sell for no tax cost, or sell it immediately and claim the tax loss this year. Those in the know are saying this loss should go on Line 23, as an ordinary loss subject to the 2% floor. Keep in mind that unless you have a bunch of other losses subject to the 2% floor, that it needs to be a decently sized whole life policy to make all this worth it.
The Pease Phase-out-Lines 29 and 30
Here is where you reduce your itemized deductions if you make what the government apparently considers to be too much. Enter the amount on Line 29 on Line 40 of your 1040.
As tax schedules go, Schedule A is one of the easier ones and usually the first one a taxpayer has to start using when they grow out of using a 1040 EZ. It's no big deal, especially the second time you do it. But understanding how it works goes a long way toward understanding our tax code.
What do you think? Do you itemize? Why or why not? What is your largest deduction on Schedule A? What have you successfully deducted on lines 20-28? Comment below!