What are Deductions?

I get this question a lot: “Can’t I just deduct that expense on my taxes?”  My answer to this question, 9 times out of 10, is that it depends.  Let us look at some basic concepts on your personal income taxes and your self-employed income below.

Standard vs. Itemized Deductions

You have your standard deduction or itemized deductions—you get to pick the higher of the two (unless Married Filing Separately-but that is beyond the scope of this article).  Your standard deduction is set by the IRS each year and it is based on your tax filing status.  Itemized deductions come from Schedule A.  The 4 most common entries on a Schedule A are:

  • Medical Expenses—this does NOT include your insurance premiums that were taken out of your paycheck.  It does include money you paid for medical expenses with any after-tax money.  The caveat here is that there is a threshold you must meet before these expenses become a number on the Schedule A.  That magic number is 7.5% of your Adjusted Gross Income (AGI).  For example, if your AGI is $100K, then the first $7500 of your medical expenses are not part of your Itemized Deductions.  If your medical expenses are $8000, then $500 will be the medical expense number in your Itemized Deductions.
  • Taxes you Paid—Think taxes paid to your State and Local government.  State Income Tax, Personal Property Tax and Real Estate Taxes paid to your state and county are the most common in this section.  There is a cap on this number which is $10K (less if Married Filing Separate), so that means that this number will not be more than $10K in your Itemized Deductions.
  • Interest you Paid—this is mortgage interest for your primary home.  It can include interest from your home equity loan IF that money from the loan was used to buy, build, or improve your primary residence.  If that money on your home equity line of credit is used to pay off other debts, then that interest does not count towards your Itemized Deductions.
  • Gifts to Charity—these are donations you make to charities—both cash and other items.
  • There are some other deductions that are less common that can go into the ‘other’ category as well.  

To get your Itemized Deductions you add all these numbers up and compare it to your standard deduction.  For a taxpayer filing as Single on their 2020 taxes, the standard deduction is $12,400.  Your Itemized Deductions should exceed the $12,400 for you use those deductions on your tax return.

Above the Line & Below the Line 

Before we talk about above or below the line, it is important to know what the line is.  ‘The line’ is your AGI—specifically Line 11 on your 1040.  Above the line deductions come off your income before calculating your AGI.  Most of these above the line deductions come from Part II of your Schedule 1 of the 1040.  Capital losses are also above the line and can only offset your income by $3K per year, but you can carry those losses forward or use them to offset any capital gains.  Below the line are credits like credits for taxes already paid, credits for self-employment taxes, child tax credits, earned income credit, education credits, etc.  

Self-Employed Deductions & Credits

If you are self-employed, most likely you will be filing a Schedule C.   What expenses offset your income?  The best starting point for this to look at the Schedule C and see the categories listed directly on the form.  There are many things that fall into each category and of course there is also the catch all ‘Other’ category.  Some of the broad categories include:

  • Advertising
  • Fees paid to Contractors
  • Depreciation
  • Employee Benefits
  • Insurance (not health)
  • Legal & Professional Services
  • Office Expenses
  • Supplies
  • Pension & Profit-Sharing Plans
  • Taxes and Licenses
  • Wages to Employees
  • Utilities 
  • Travel and meals (there are some caps here)

All the above get you to your net income for your business.

Potential credits on your 1040

  • Self Employed Health Insurance—if the plan is established under your business, you could deduct premiums paid for your health insurance for you, your spouse and dependent.  You also must have net income from your business to be able to do this.  Check out the Self-Employed Health Insurance Deductions worksheet in the Form 1040 instructions.
  • Qualified Long-Term Care Insurance—you can deduct a portion of your premium based on your age.  
  • Self-Employment Tax—when you are self-employed, you must pay both the employEE and employER part of payroll taxes.   Uncle Sam gives you a little bit of break and allows you to deduct ½ of your Self Employment Tax on your 1040.
  • Don’t forget you have to pay your Self Employment Taxes quarterly (3/15, 6/15, 9/15 and 1/15 for the previous quarter).
  • Self-Employed Retirement Plan Contributions—note that this depends on the type of plan you have.  This will only be a deduction if you are NOT contributing to a ROTH plan.

WOW, that was a lot of information and only a high-level overview of some deductions!  Click here to get more information on common tax forms.

Financial Journey LLC is a registered investment advisor offering advisory services in the state of Virginia and in other jurisdictions where exempted.  Information provided is for educational purposes only and not, in any way, to be considered investment or tax advice.