Tax Deductions: Above-the-Line, Standard, Itemized, and Miscellaneous

February 18, 2009 by TFB

I wrote about tax credits last week. This time let's look at tax deductions. First a recap of the difference between a tax credit and a tax deduction:

A tax credit directly reduces your tax dollar for dollar. If you are supposed to pay $5,000 in tax, a $500 tax credit reduces your tax to $4,500.

A tax deduction reduces your taxable income, which indirectly reduces your tax. If you are supposed to pay $5,000 in tax, a $500 tax deduction reduces your taxable income by $500 which then reduces your tax by only $500 * 15% = $75 if you are in the 15% marginal tax bracket.

Therefore a $100 tax credit is worth a lot more than a $100 tax deduction.

Within tax deductions, there are above-the-line deductions, standard deduction, and itemized deductions.

Above-the-line deductions are officially known as adjustments to income. The "line" refers to the last line on page 1 of your Form 1040 or Form 1040A, which is labeled adjusted gross income (AGI).

That AGI is the magic number that determines eligibility for many tax breaks. Above-the-line deductions reduce that magic number. They can be taken even if you use the standard deduction and not itemize your deductions. An above-the-line deduction also passes through AMT, whereas some of the other deductions are disallowed under AMT.

Therefore a $100 above-the-line tax deduction is better than a $100 below-the-line deduction. The new tax deduction for sales tax when you buy a new car is an above-the-line deduction.

I think most people already know the difference between standard deduction and itemized deductions. So I'm not going to waste your time. I do want to point out just because an expense is tax deductible, it doesn't mean you can actually take the deduction.

I know it sounds weird but it's true. It took me a while to figure out many exciting deductions are only deductions in theory. Most people can't really take them. This is because some deductions must first clear a floor before they can be deducted.

For example medical expenses are tax deductible, but you can only deduct the portion which exceeds 7.5% of your AGI. For many people that means zero.

Theft losses are also tax deductible, but only the portion which exceeds 10% of your AGI. That's a very high hurdle.

Safe deposit box rental fees and tax preparation fees are also theoretically tax deductible, but few people can actually deduct them because them fall into a bucket called miscellaneous deductions, which are subject to a floor of 2% of AGI. All your miscellaneous deductions added together must exceed 2% of your AGI before you can deduct anything.

For example, suppose your AGI is $80,000, 2% of your AGI is $1,600. If you have $1,700 in all miscellaneous deductions, you can only deduct $100. If you have $1,500 in all miscellaneous deductions, you can't deduct anything.

Therefore most miscellaneous deductions are practically useless.

The following table lists some of the tax deductions (as of 2008 tax year) in alphabetical order. I'm not enumerating miscellaneous deductions here because there are simply too many. All the links point to the official IRS web site for that topic. Every tax deduction has a unique set of qualification rules. Out of 19 tax deductions listed here, 11 are above-the-line; the other eight are itemized deductions.

Tax Deduction	Above-the-Line?
Alimony Paid	Yes
Casualty and Theft Losses	No, 10% AGI floor
Charitable donations	No
Educator Expenses	Yes
Health Savings Account	Yes
Investment Interest	No
Medical and Dental Expenses	No, 7.5% AGI floor
Miscellaneous Expenses	No, 2% AGI floor
Mortgage Interest and Points	No
Mortgage Insurance Premiums	No
Moving Expenses	Yes
Property Tax	No
Qualified Performing Artists	Yes
Self-Employment Health Insurance	Yes
Self-Employment Retirement Plan Contributions	Yes
1/2 of Self-Employment Tax	Yes
State Income Tax or Sales Tax	No
Student Loan Interest	Yes
Traditional IRA Contributions	Yes
Tuition and Fees	Yes