Itemized Deduction

DEFINITION of 'Itemized Deduction'

An itemized deduction is a tax deduction from a taxpayer's adjusted gross income that is made up of multiple expenses for money spent on certain goods and services throughout the year. The specific deductions that are allowed are outlined by the Internal Revenue Service (IRS) and include such expenses as mortgage interest, state and local taxes, gifts, and medical expenses.

BREAKING DOWN 'Itemized Deduction'

Every year, the US government provides tax relief to tax payers in the form of tax credits or deductions. A tax credit reduces the final tax bill of a taxpayer. If an individual’s tax liability sums up to $15,000 and he qualifies for a $3,500 tax credit, he will only have to pay $11,500 in tax. A tax deduction reduces the taxpayer's taxable income. If a single filer’s taxable income for the tax year is $75,000 and he falls in the 25% marginal tax bracket, his total marginal tax bill will be 25% x $75,000 = $18,750. However, if he qualifies for an $8,000 tax deduction, the 25% tax rate will apply to $67,000 taxable income, not $75,000.

A tax deduction can either be claimed as a standard deduction or an itemized deduction, depending on which deduction type lowers the taxpayer’s liability the most. Deciding whether to file taxes with standard or itemized deduction is important given that only one method can be used in a given tax year. A standard tax deduction is a fixed dollar amount that reduces taxable income, and the amount depends on the tax payer’s filing status. For 2017, a single taxpayer can claim $6,350 standard deduction, while one who is married filing jointly can claim $12,700.

Itemized deductions are expenses allowed by the Internal Revenue Service (IRS) to decrease a taxpayer’s taxable income. Itemized deductions allow an individual to list out qualified expenses on his tax return, the sum of which is used to lower his adjusted gross income (AGI). Individuals will opt for itemized deductions if the sum of qualified expenses is more than the fixed amount provided under the standard deduction. For example, if a single taxpayer’s total itemized expense is $7,500, he will likely choose to itemize rather than apply the standard deduction to his adjusted gross income. On the other hand, a single taxpayer with qualified deductions of $5,000 will most likely opt for the standard deduction of $6,350.

Not all filers have the option to choose whether to itemize their deductions or claim the standard deduction. Non-resident aliens must itemize their deductions. Also, married couples that are filing separately must claim the same type of deduction. If a spouse itemizes deductions, her partner must also do the same.

Mortgage interest; mortgage insurance premium (MIP); charitable donations; medical and dental expenses; personal property tax; state and local sales tax; gambling losses; investment interest; tax preparation fees; and home office expenses are few of the multiple qualified expenses that can be itemized on a tax return. Individuals who frequently spend large amounts on medical care, state and local taxes, donations, or other deductible expenses may be better off itemizing. Itemized deductions are filled out on Schedule A of Form 1040, and take a longer time to fill out than the standard deduction since taxpayers will have to input each expense item line by line on the form. The shorter and simpler 1040A and 1040EZ Forms cannot be used to itemize deductions. In addition, an individual, such as a freelancer or homeowner, needs to save all receipts for any expenses made throughout the tax year as proof that the expenses are legitimate in the event that the IRS asks for documentation. Additional proof of expenses includes bank statements, insurance bills, medical bills, and tax receipts from any qualified charitable organization.

Usually, an itemized deduction is limited to a certain percentage of adjusted gross income. Tax laws set thresholds in spending that must be exceeded before the deductions can be made. For example, in the medical category, only expenses that exceed 10% of your adjusted gross income may be deducted (7.5% if 65 years or older). If you didn't spend at least that much, then none of your medical expenses will be deductible. For example, a single taxpayer with adjusted gross income of $85,000 has qualified medical expenses of $11,500 for the tax year. 10% of his AGI is $8,500. The portion of his medical expenses that exceeds 10% of his AGI is $11,500 - $8,500 = $3,000. Therefore, the taxpayer’s deduction for the medical item is limited to $3,000. For charitable contributions, total deductions cannot exceed 50% of Adjusted Gross Income. Also, to claim a deduction on gambling losses, the losses cannot exceed the winnings.

The total amount of itemized deductions that can be claimed is reduced or phased out if the taxpayer’s AGI exceeds the set limit for his filing status. The limits are shown in the table below:

Filing Status Adjusted Gross Income Limit
Single $261,500
Head of Household $287,650
Married Filing Jointly & Surviving Spouses $313,800
Married Filing Separately $156,900

Some deductions are exempt from the limit rule. These include medical expenses, gambling losses, investment expenses, and certain casualty and theft losses.

The reduction rate that will be applied if the taxpayer’s AGI is above these limits is 3% of the amount by which the AGI exceeds the threshold or 80% of total non-exempt itemized deductions, whichever is less. The itemized deduction limit increases with each dollar earned above the AGI limit up to a maximum of 80% of total deductions. These limits on AGI are known as the Pease limitations. For example, consider an individual filing her returns as head of the household with an AGI of $300,000 for 2017 and total itemized deductions of $50,000. Of her total itemized deductions, $45,000 are non-exempt deductions. The excess or difference between the stipulated limit (as seen in the table above) and her AGI level is $400,000 - $287,650 = $112,350. Since the Pease Limitations reduce her deductions by 3%, the total deduction that she can claim is $45,000 – (3% x $112,350) = $45,000 - $3,370.50 = $41,629.50.

Individuals subject to the Pease limitations will need to complete the Itemized Deductions Worksheet to determine the amount to enter on line 29 of Schedule A.