Maximize Income Tax Deductions

Maximize income tax deductions to reduce taxable income

Strategy Overview

Stock compensation can significantly increase your income in a given year. When this happens, strategically considering if/how to maximize tax deductions in the same year can help reduce your taxable income (and total tax bill). As you might expect, this specifically focuses on deductions you have significant control over. Most commonly, those are retirement account contributions, charitable donations, and healthcare/medical expenses.

Tax Details

The U.S. federal income tax system provides opportunities for taxpayers to reduce their taxable income and total tax liability via tax deductions. There are two main categories of tax deductions: (1) Above-the-line deductions, and (2) Below-the-line deductions. Last, there are also tax credits (which are 1:1 offsets for taxes due, rather than reducing your taxable income) which are not covered in this article.

Above-The-Line Deductions

Above-the-line deductions are expenses that directly reduce your taxable income. Many have maximum limits specified by the IRS (e.g. you can contribute a max of $22,500 to your 401k in 2023), but if you have dollars allocated to an above-the-line deduction, you get to subtract those from your gross taxable income to determine your AGI (Adjusted Gross Income). The most common above-the-line deductions you have control over include:

• Retirement plan contributions. 401k, 403(b), IRAs (subject to phase-out)

• Healthcare-related expenses. Premiums paid for employer-health-insurance plans and HSA/FSA account contributions. Technically, these are paid with pre-tax dollars (instead of being a deduction on your taxes). But they functionally result in the same outcome.

• Other items. Student loan interest, select tuition expenses, alimony, home office expenses (if self-employed).

Below-The-Line Deductions

Below-the-line deductions are expenses that may reduce your taxable income. Every taxpayer gets to choose from either (i) a standard deduction, or (ii) itemized deductions when they file their taxes; and individuals naturally select the higher of the two. Post the tax law changes in 2018, the standard deduction is higher for most tax filers.

If you're like most (standard > itemized), then new below-the-line deductions won't help you reduce your tax bill. But if (i) your itemized deductions are greater than the standard deduction, or (ii) you can/desire to create itemized deductions in a size large enough to flip from standard to itemized -> then you have additional tools/considerations to potentially reduce your tax bill. For additional color and details:

The standard deduction is a set dollar amount that taxpayers can deduct from their income based on their filing status (single, married filing jointly, etc.). You get it no matter what, and it generally increases each year (because it is inflation-adjusted).

Itemized deductions are IRS-specified expenses that one is allowed to deduct if they opt for itemization. Generally, each itemized deduction requires one to have/provide evidence of the expense. The most common Below-the-Line deductions that count towards itemization include:

• Mortgage interest. Interest paid on a primary residence and second home is deductible, up to certain limits. In certain situations, this may also include interest on HELOCs.

• State and local taxes (SALT). State/local income taxes and property taxes can be deducted, up to a combined limit of $10,000.

• Charitable contributions. Gifts to qualified charitable organizations are generally tax deductible. Limits apply based on income and type of asset donated. There is also a dedicated sub-strategy related to this: Charitable Donation Stacking and DAFs for 2-3x Tax Benefits

• Medical expenses. Qualified medical expenses exceeding 7.5% of adjusted gross income are deductible. This is separate from (and excludes) any Above-the-Line deductions already taken for health insurance premiums and/or HSA/FSA contributions. If you anticipate large medical expenses in the next two years, one strategy is to consider "grouping" those expenses all in one year (to maximize the dollars above 7.5%)

Some deductions phase out at higher income levels. Careful planning is highly recommended

Key Benefits

• Lower taxable income and total tax liability. Strategically assessing and maximizing your tax deductions reduces the amount of income subject to tax, directly lowering your tax bill.

Key Considerations/Flags

• Many deductions have trade-offs or financial commitments. For example, maxing out your 401k will reduce your tax bill. But if doing so would create a financial strain, or if you are in a low tax bracket where making Roth 401k contributions may be a better choice, then it may not be the overall best choice.

• Make sure to consider eligibility rules and caps on certain deductions. Many deductions have income limits, phaseouts, and/or dollar caps tied to them (e.g. state/local taxes (SALT), mortgage interest, retirement accounts). Make sure you fully understand the rules for each.

• Itemized deductions (below-the-Line) are relatively uncommon and require significant deductions. In 2022 it is estimated that 85-90% of households use the standard deduction (vs itemizing). If you're somewhat close, there are itemization strategies that may make sense to consider. Otherwise, it may not be a logical path to consider.

Strategy: When to Consider This and When to Avoid It

🟢 When to Consider This Strategy:

• When you have the financial resources to be able to commit to fully funding your (and, if applicable, your spouses) 401k plan(s).

• You have sizable expenses in categories like mortgage interest, state/local taxes, charitable donations, medical bills, etc. that could allow you to exceed the standard deduction.

• You frequently give to charity, and have the flexibility to "stack" those deductions in one year (typically via a Donor Advised Fund), resulting in being able to itemize vs. use the standard deduction.

• You have an abnormally high-income year that you don't expect to repeat, which has pushed your marginal tax rate into a higher tax bracket.

🔴 When to Not Use This Strategy:

• [Potentially] if your income is large, resulting in the phase-out of certain deductions.

• Contributing more to your 401k would strain your finances.

• The standard deduction is much larger than your calculated itemized deduction (i.e. it would take a lot to make itemized > standard).

Example