Often when I'm out and about chatting with friends, the topic of finance seems to come up a lot. It probably comes up more for me than most! I think this is because my mind is always running through scenarios to optimize and improve financial actions and habits. For some people financial topics make their stomach turn, but for me they spur creativity and joy. So, when these casual conversations do occur, it is likely that I am subconsciously steering the conversation to finance because it is something that I really enjoy talking about.
Among conversations with friends who are doing “well” for themselves, I have heard the statements repeatedly, "I must buy a house, I need the deduction." or "I make over 100k, I need a tax break!" While I am 100% in support of any thinking that steers people towards buying assets (like a house), versus liabilities (like a car), people are often very surprised by what they find out when we go a little bit deeper in the conversation.
It comes down to a simple understanding of how taxes work. This little nugget of knowledge can have a substantial impact on your decision making and expectations of what actually occurs with Uncle Sam (the IRS). What everyone needs to know is what the standard deduction is, versus an itemized deduction.
Let’s start with the standard deduction. This is an amount that the IRS recalculates each year, and that you receive as a base deduction from your work income. You receive this deduction per person. So if you are single it is just one deduction, and if you are married it is a joint deduction. For a single filer in 2022 the standard deduction is 12,950; and for a married couple it doubles to 25,900. Now there are some complexities to this, but to paint a simple picture ... If a married couple earns 100k ... they will get to subtract 25,900 from their income and pay taxes on the remaining 74k or so.
This seems generous, right? 25k in deductions without having to take much action is great! Many people don’t realize this because for many years the standard deduction was much lower. In 2016, for example, the standard deduction was just 6,400 for a single filer, and 12,800 for a married couple.
With these numbers in mind, let's jump to the itemized deduction. This is where the realtors will tell you ..."a house is your best investment; you get a great tax break!" But just let's see about that... The itemized deduction can include several items, which get added together to create the total deduction that you (might) receive. Here are a few examples of what can be itemized… 1. Interest you pay on your primary home’s mortgage. 2. A portion of the medical expenses you pay. 3. Charitable donations you make. 4. State income taxes you pay. 5. State property taxes you pay. For our married couple with the 100k in income, let's use the following estimates for their itemized taxes (Again, these are hypothetical numbers, but they have a reasonable expected accuracy for a couple with this income level): 1. Couple has a 400k mortgage at 3% interest, and this is their first year of a 30-year fixed loan. The first-year interest paid is about 12,000. 2. The couple donated 500 dollars to charity. 3. Couple had 3,000 in CA state taxes. 4. 5,000 in property taxes. Let’s add all of these up: (12,000+500+3,000+5,000) = 20,500.
With 20,500 of total itemizations, the couple would not get the itemized tax benefit from having a mortgage, nor from their generosity to the charity!
The crux of all this is you only get to take the deduction of the greater of the two: the total itemized or the standard deduction. For our couple making 100k, all the itemized deductions added together (20,500) still do not exceed the simple standard deduction of 25,900. If we look back to 2016 however, this couple would have wanted to itemize. This is when the standard deduction was around just $12,000 for them. With total itemizations of about $20,000, this couple would have 8,000 more to deduct from their income by itemizing than by taking the standard deduction.
This is just one of the reasons why it is so important to make financial decisions based upon quality, and up-to-date information. Although your friends and family at the social gathering may give you unsolicited financial advice on topics like this, it is important to seek current, and factual information from a credible source. Our social exchanges are full of riveting dialogues, and it can be fun to talk about finance .... but let’s keep the musts, have-to's, and non-personalized financial advice out of it. So for the married couple making 100k, enjoy your above the national average household income ... and your standard deduction as well!
Disclosure: Bridge The Gap Retirement Planners LLC (BTGRP) is an Investment Advisor registered with the States of CA/AZ. All views, expressions, and opinions included in this communication are subject to change. This communication is not intended as an offer or solicitation to buy, hold or sell any financial instrument or investment advisory services. Any information provided has been obtained from sources considered reliable, but we do not guarantee the accuracy, or the completeness of, any description of securities, markets or developments mentioned. We may, from time to time, have a position in the securities mentioned and may execute transactions that may not be consistent with this communication's conclusions. Our current disclosure brochure, Form ADV Part 2, is available for your review upon request, and on our website, btgretirementplanners.com. This disclosure brochure, or a summary of material changes made, is also provided to our clients on an annual basis