Episode 5: What Are Tax Deductions Really Worth?

Steven Jarvis:     Hello everyone, and welcome back to The Retirement Tax Podcast. I am your host, Steven Jarvis, CPA. And here with me as always is the incredible Benjamin Brandt. Ben, welcome back.

Benjamin Brandt:         Greetings, Steven. So happy to be back. I always look forward to these times we share together.

Steven Jarvis:     Yeah. Recently, we got to share some in person time together and run a Spartan race, which, if you haven’t done that before, maybe you don’t want to. It was a lot of fun, but it certainly wasn’t your typical weekend.

Benjamin Brandt:         I’ve still got cuts and bruises that are healing. I was emotionally crushed when I missed a spear toss. I got back in line, tried again, missed it twice. So my Viking ancestry is not doing me the favors that I thought it might.

Steven Jarvis:     Yeah, next time. You’ll get them next time.

Benjamin Brandt:         Next time. But it was so much fun. If you have a chance to do any Spartan races, you’re going to crawl through mud. You’re crawling under barbed wire. You’re climbing, all the things that you’d picture, you’re going to do. But man, it’s a lot of fun, especially if you do it with a group of friends. And Steven enjoyed it so much, he ran the race … He’s too humble. He wouldn’t say this himself, but he ran the race, got second place, got back in line with us slow people and ran it again, so hats off to Steven.

Steven Jarvis:     Wow. And mostly we share that just so that we can slowly break down the stereotypes you all have in your heads of CPAs and CFPs and what we do in our spare time because we are people. We do have fun sometimes.

Benjamin Brandt:         That’s true. Yeah, we do the standard amount of fun, unless we itemize. And maybe that’s what we’re talking about today.

Steven Jarvis:     Maybe that is what we’re talking about today. That’s a great segue. I love play on words. Yeah, so today we want to talk about what your tax deductions are really worth. And the reason this topic came up because tax deduction is kind of something that just rolls off of everyone’s tongue, just those words, but it’s really commonly misunderstood, and usually to the detriment of the taxpayer of, hey, I get a tax deduction for whatever it might be, when in reality, since the Tax Cuts and Jobs Act, most people, AKA, 90% of taxpayers are not actually itemizing their deductions. So a lot of those things that you think are tax deductions don’t have any benefit to you.

Benjamin Brandt:         And when you say 90%, Steven, are you saying the vast majority, or is it actually 90%?

Steven Jarvis:     That’s a good point. Sometimes people just throw out percentages of what comes off the top of their head. Literally, according to a study that was done in 2018, which was the first year after the TCJA went into effect, only 11.5% of taxpayers actually itemized. And if you start looking at income bands, the number gets even smaller. So people with income under $200,000, the percentage was single digits.

Benjamin Brandt:         So it’s darn near everybody under $200,000, the standard deduction is going to be more generous than adding up all of your receipts and things like that at the end of the year.

Steven Jarvis:     Yeah. And the standard deduction right now is very generous. For single filers for 2021, it’s going to be $12,550. For married, filing jointly, it’s $25,100. And then of course, if you are either really experienced in life, which is the nice way of saying you’re over the age of 65, because that’s what the IRS picked as their age, you get an extra bonus on your standard deduction, or if you’re blind, which why blind and not deaf just reinforces that everything in the tax code has somebody lobbying behind it. And don’t try to look for the rationale behind these tax rules.

Benjamin Brandt:         Okay. So if I’ve never heard that number before, Steven, I’m married, so $25,100 for this tax year that we’re in now. What significance does that number have? Do I need to save receipts to get to that number? Or how does that number apply to me if I know nothing about taxes, let’s assume?

Steven Jarvis:     Yeah. So the standard deduction is a reduction of your income to get to what’s actually going to be taxable. And so your options are either you take the standard deduction that anyone can take based on your filing status, or you can itemize, which Ben, you mentioned earlier. And for itemizing to make sense, those deductions have to add up to more than that standard deduction. And so let’s talk about what some of those itemized deductions might be. And then we’ll talk about how the math really works on this.

Benjamin Brandt:         Okay. So the standard deduction is kind of our line in the sand, and then there are certain times that we’re going to go through that we can add these up and try to beat that number. But the default is going to be whichever is the most generous for us. Is that right?

Steven Jarvis:     Yes. Yes. We definitely want to pick the higher number because it’s reducing our taxable income.

Benjamin Brandt:         Excellent, okay. So let’s go through. Tell me what kind of receipts I need to be saving and thinking about.

Steven Jarvis:     Yeah, so usually the first one that people think of when they think of things they can deduct for taxes is their mortgage interest. This one comes up all the time. Sometimes we’ll get on just a little bit of a tangent here. And sometimes people get a little carried away with this of, hey, I don’t want to pay off my mortgage because then I won’t be able to deduct the interest. Just so we’re clear, your actual benefit is actually a percentage of whatever the deduction is. So even if we say for a second that you could deduct all of your mortgage interest, you’re only going to get a percent as an actual tax benefit. If your marginal tax rate is 22% and your interest was $1000, your tax benefit is $220, not $1000. So don’t ever hold off paying off your mortgage just because you want the interest. The math’s not going to work out for you on that point.

Benjamin Brandt:         And if anybody doesn’t believe that, I’d like to extend an offer to our audience. Anybody that wants to send me $1000, I will gladly send you $220 back.

Steven Jarvis:     Oh, yeah. Yeah, that’s a very generous offer. I’ll send you $330.

Benjamin Brandt:         Excellent. And I think people don’t understand that. They think I get a deduction because of my mortgage interest. Now this doesn’t mean take $500,000 out of your IRA and pay it off. That’s something entirely different. But people think that I’m getting a tax deduction, so I should hold onto this mortgage, when in reality, you’re sending the bank $100 in order to not send the IRS $10. Right?

Steven Jarvis:     Yeah. Yeah, so that’s one that a lot of people are aware of. The other ones, and these all are on Schedule A, the IRS form associated with the 1040, and Schedule A is where we itemize deductions. So the home mortgage interest, state and local taxes, medical and dental expenses, and gifts to charity are biggest buckets of potential itemized deductions. But each of these have some things we’ve got to think about beyond just how much we paid. For example, for state and local taxes, under the Tax Cuts and Jobs Act, this got capped at $10,000. Now if you’re like me and you’re from Washington state, you might be thinking, “Well, how does anyone ever get to $10,000 in state and local taxes?” Because Washington state doesn’t have an income tax, but it turns out, that’s the exception and not the rule. And for a lot of people, that $10,000 cap really limits their ability to itemize their deductions because they might pay $15,000, $20,000, $30,000 in state income tax and only get a potential benefit of that $10,000.

Benjamin Brandt:         Excellent. And if I’m thinking, so I’ve got six kids, and if I’m thinking back, I’ve only ever been able to take advantage as an itemized deduction of the medical and dental expenses one time. I think we had braces and a few pretty hefty doctors trips in one year. But let’s talk a little bit about medical and dental expenses. Am I able to … I’ve got $10,000 in medical expenses. Is that just a straight deduction off of my income, or how does that work?

Steven Jarvis:     No, so medical and dental gets its own little extra condition. And for that one, it’s that you can only deduct the amount of medical and dental expenses that are over 7.5% of your adjusted gross income because nothing can be simple with taxes, and so the IRS is constantly kind of throwing these different things at us. So we want to keep track of our medical and dental expenses because there could be years where this is relevant or we could take advantage of this, especially with six kids. There’s probably going to be a year where that might be relevant. But we have a floor on this one of saying, “Okay, we can’t even start adding these to our Schedule A until they’re over 7.5% of our adjusted gross income.

Benjamin Brandt:         Okay. So if your income is higher than the medical expenses, it would have to be much more significant for it to apply, or if you had an unusually low income year, and an average or a high medical expense year. So keeping that in mind, 7.5% is sort of the table stakes, it’s that 7.5% plus a penny, and then the penny counts towards the standard deduction. And then that still has to beat the standard deduction to get us anywhere.

Steven Jarvis:     Yeah. So let’s talk about gifts to charity really quick, and then we’ll talk about just kind of the overall math on when it makes sense to itemize and what tax benefit you’re actually getting. So with gifts to charity, in general, if you’re giving cash to a qualified charitable organization, Girl Scouts, your local church, other community organizations that you’re passionate about, if it’s a cash gift, typically, that can be included 100% on Schedule A. There’s some limitations if we’re giving, if we’re donating non cash items, but still, there’s some potential opportunity to be able to include this on a Schedule A as we’re giving to qualified charities.

                           So those are our four biggest buckets when it comes to itemized deductions, medical and dental expense, state and local taxes, home mortgage interest, and then gifts to charity. So now let’s talk about how this all stacks up and compares to the standard deduction. So in a given tax year, even if I have $0 in all of these categories, I can still take the standard deduction. And I happen to be married, I file jointly, so no matter what else I do, at a minimum, I can take the standard deduction of $25,100. So like you said, Ben, that’s kind of the benchmark we’re working against.

                           So if that was last year, I had nothing else, I had zero in the column of itemized deductions. So I took the standard at $25,000. So let’s say this year, I give $10,000 to charity. Now for a lot of us, in our minds we’re thinking, “Oh, that’s a tax benefit,” and in fact, the charity’s probably going to send you some kind of receipt or acknowledgement of your gift for tax purposes. And so you’re thinking, “Great. I’ve got this letter. I donated $10,000. I’m going to get a $10,000 tax benefit.” So for me, if I have nothing else to itemize, I get zero tax benefit. Right? Because I gave $10,000 to charity, but the standard deduction is $25,100, it’s still higher, so there’s no tax benefit. I still got to support a great organization, and that’s why I gave, but there’s no tax benefit. And we want to make sure that we’re not confusing these things.

                           Let’s go another year forward and say I went out and bought my dream home, and I took out the mortgage to do it. And I moved to a state with income tax, and so now I’ve got between my mortgage interest and my state and local taxes, I’ve got $20,000 of itemized deductions, and then I give my $10,000 gift to charity. So now I’m up to $30,000 total in itemized deductions, which hooray, is over the standard deduction. But again, I can’t think about these individually as, oh, that $30,000 I spent was all a tax benefit to me. It’s only the amount over the standard deduction that’s really getting me any benefit because the standard deduction would’ve been there all along.

                           And so then we can start getting into different proactive strategies that we can apply to maximize the years where we do itemize versus the years where we take the standard deduction. And we’re going to do a whole separate episode getting specifically into some of the things around charitable deductions because there’s a couple of really cool things that we can do to get that tax benefit. But in general, this is where it’s good to be thinking about our taxes more than one year at a time, so that either as we have higher or lower income years, or higher or lower expense years, we can start being strategic about how we group these things to make sure that we are not overpaying the IRS anytime we can avoid it.

Benjamin Brandt:         Right. I think that especially makes sense as we are transitioning to retirement or living off of our portfolio in retirement because that’s really our advantage over the IRS, is we can say, “I’m not earning this income anymore. I’m deciding when I’m going to take it,” especially if we’re liquidating a portfolio in order to create monthly income, so we can decide. Are we liquidating a little bit more this year, or a little bit less? To take advantage of some of these areas, the items, where we can try to beat the standard deductions. So the whole game changes in my view when we’re retired because we have much more control and have much more ability to make our income flexible, accelerate our income in certain years, have less income in later years, things like that. So a lot of these things, we’re going to be covering in future episodes, especially our next episode with charitable giving, but something to think about. The whole game changes once you start living off of your savings.

Steven Jarvis:     Definitely. Definitely. The IRS is going to ask us for our tax payment every year. It really just comes down to: Are we going to be proactive about how much we pay them in a given year? The only other thing I was going to add is that I will have some people say, “Well, wait a second. I give to charities to support these organizations, not to get a tax benefit.” And I 100% agree with that. You should be giving because you care about the organization, because just like Ben offering to give you $220 if you send him $1000, you’re not going to come out ahead by getting a tax benefit on charitable contributions you weren’t already intending to make. But that being said, if we’re proactive and save a little bit more on taxes, that just leaves you more you can give to those great organizations, so I think it’s still worth considering.

Benjamin Brandt:         Absolutely, yeah. Give because you want to give, not necessarily for the tax deduction first. Give because that’s something that means something to you, but the tax benefit, if there so happens to be one, and there’s not in every case, that’s just a little gravy on top. Right?

Steven Jarvis:     Yeah. All right. Well, hopefully that was helpful for just kind of breaking down that standard versus itemized deduction. Now Ben, why don’t we pivot and talk about some listener questions?

Benjamin Brandt:         Excellent, excellent. So when we were thinking about starting this show, I floated the idea to my retirement starts today community in our listener survey. And as a thank you for people taking the survey, I sort of teased that we were going to start this show. And hey, if you have any tax related questions, go ahead and drop those in. So I don’t know what the exact number of questions we were, but it should keep us busy for quite some time. Is that right?

Steven Jarvis:     Definitely. I’d have to go back and look at the exact number, but it was hundreds.

Benjamin Brandt:         I want to say hundreds, yeah, hundreds, way more than 100, probably not 1000, so somewhere in there. But question number one, so we’re asking the CPA, question number one. Calculating IRS withholding seems to be more of an art than a science. I generally end up making a change, then see what is withdrawn from the next pension payment, then adjust. Is there a better way? So I’m assuming this is a question specifically asking about: How do I change and what amount do I change to my pension withholdings? I suppose this would also apply to social security, IRA withdrawals, things like that as well.

Steven Jarvis:     Yeah. So let’s just talk about withholdings in general for a second, which we love to be able to withhold taxes as opposed to making estimated payments when we can because the IRS gives preferential treatment to withholdings. And that’s not too far off, there’s a little bit of an art to it. At the end of the day, if you wanted to look at this on a real regular basis, we could get it really dialed in. You could hire a nerdy person like me and we could get it just really dialed in. But at some point, there diminishing returns. We want to get close, and so really the general idea of let’s estimate what we think our tax liability is going to be, and then revisit it at some point and adjust, that’s kind of the format you want to follow. Typically, I want to look at this for myself personally, I look at this before the end of the year, so that I know going into this next year, what’s that kind of going to look like, so that I start the year on the right track.

                           And then usually at the latest in September, I’m estimating. Okay, what’s the rest of my year look like? And should I change any of my withholdings? And depending on the source of your income, there’s going to be some variation of the form W-4 to adjust those withholdings. And we can adjust withholdings both from W-2 wages, or social security, or from a pension, or from IRA distributions, although the IRA distributions aren’t on the W-4. But there’s proactive ways to adjust any of those things.

Benjamin Brandt:         Okay. Now other than just sort of mental kudos, there really isn’t a benefit of getting the number exactly on. Right? There’s some wiggle room that the IRS has built in for us that we don’t have to … If we’re a dollar off, we’re not going to start paying penalties and interest and things like that, which is actually the question number two. What is the tipping point for paying a penalty for underpayment?

Steven Jarvis:     Yeah. This is a great question because the question that usually goes along with this is: How much of a refund should I get? I mean, to your point, Ben, other than your gold star that you’re going to give yourself, getting it exactly right doesn’t really have a benefit, as long as we didn’t underpay by so much, the IRS is going to charge us an underpayment penalty, which is possible. For a lot of us, it’s not very likely because the IRS has what they call safe harbor provisions. And so the way the safe harbor provision works is that if we owe less than $1000 at tax time, then it doesn’t matter that we weren’t spot on, we’re not going to get an underpayment penalty. So that’s the first one, if we owe less than $1000 at the end of the year.

                           The next one is if we paid at least 90% of our current year tax liability before tax time. So for simple math, if the total tax you owe throughout the year was $10,000, as long as you paid $9000 of it before the end of the year, then you’ll be fine. There’ll be no underpayment penalties. And then the last safe harbor provision, and this is really important for years where our income is fluctuating, is if we paid 100% of last year’s tax liability in the current year, then no matter what our tax liability is this year, we’ve still hit that safe harbor provision. So if our income changes drastically, this can actually be pretty impactful. And this might be that we had a large one time taxable distribution, whatever life event caused us to go from, let’s say $100,000 in income last year, to $500,000 of income this year, and then our taxes also went way up, that safe harbor is still going to be based on the taxes we paid last year, which kind of gives us a longer window to having paid all of those taxes if we want to take advantage of that.

Benjamin Brandt:         Okay. So we’ve still got to pay … So income goes from $100,000 in 2020 to $500,000 in 2021. We’ve still got to pay all those taxes one way or another.

Steven Jarvis:     Yes.

Benjamin Brandt:         But if we pay, it’s 100%, we pay the same bill we would’ve paid last year, we’ll have to still pay the taxes, but there’s not going to be underpayment penalties.

Steven Jarvis:     Yeah, because the IRS has what they call a pay as you go system, and so the IRS expects you to pay your taxes as you earn your taxes. And so if they’re not being withheld directly from a paycheck or a pension payment, the IRS has quarterly estimated payment deadlines that happen throughout the year, the last of which is January 15th, not April 15th. So if we wait and pay too much of our taxes at the tax deadline, we potentially are going to pay this underpayment penalty, and so that’s where these safe harbor provisions come into play, is that we need to have met those safe harbor provisions by January 15th to make sure that we’re not going to be subject to any of those underpayment penalties.

Benjamin Brandt:         Okay. I was just trying to think of situations where income would go up a lot as we approach retirement. And of course, Roth conversions is one that jumps into mind, but also an inheritance. That’s something that we really couldn’t plan for ahead of time, but something, a situation you might find yourself in mid tax. And while it would be an incredible blessing to get an inheritance, there could be some stress involved, not understanding how much taxes are owed. I assume most people would assume that there would be taxes, but there could be some stress around: Am I going to have to pay interest and penalties because my income has gone up so much? So as long as we have last year covered, we should be good. Now is that at all income levels? Do we have to beat the safe harbor by more if our income is higher?

Steven Jarvis:     Yeah. So for the 90% of the current year, that’s regardless of income level. But when we look at the prior year, it goes up to $110,000. And I don’t have that number … $150,000 or $200,000 of income, I don’t have that number right in front of me.

Benjamin Brandt:         $150,000 is what kind of pops into my head, but it’s around that.

Steven Jarvis:     Yeah. So as you go up a little bit, it becomes 110% of the prior year as opposed to 100%.

Benjamin Brandt:         So in the situation where you get an inheritance, yeah, cover last year’s 100% plus 10% and you should be fine. But like anything else, contact your financial advisor, contact your CPA, and they’ll know for sure. Even if we can’t dial that into a dollar, if we can remove the surprise come April, hopefully we’re proving our worth. Right?

Steven Jarvis:     Yeah. Honestly, for me personally, my goal is that I get a refund of less than $1000 because I don’t like having to write a check to the IRS in April, and I want it to be fairly close. So a refund of less than $1000 is what I always shoot for.

Benjamin Brandt:         I love it. That would be the perfect amount. And our final question to close on, which actually kind of sums up what we’re just talking about here, stress to folks that tax withholding may be different for different sources of income. So one might have to overpay one source of income to make up for another source that is not taxed upon withdrawal, or make a quarterly tax payment, or other suggestions. This is something that comes up in our office from time to time in that we have to check with clients what their withholding is on social security, for example. We might be withholding 15% from their IRA distributions to make up for a 0% tax withholding on social security or some other form of payment. And with social security, once it’s set, it’s sort of a set it and forget it. Right? Very few people are going to go back and figure out how to change that. So what would your answer be? How would you modify those payments for things you might not need a withholding for by mandate, versus things that are more voluntary?

Steven Jarvis:     So I think this is where the power of doing a tax projection comes in. And depending on how complex your situation is, sometimes you can find just online calculators that’ll help you do a basic one. Maybe that first year, you retire and your income sources are changing a lot. It’s worth finding a professional to help you to say, “Okay. How does this all line up?” Because if you just look at these different sources individually, you can have some surprises at the end of the year. And so at some point during the year, you kind of got to try to bring it all together and say, “Okay. What’s my total taxable income going to be at the end of the year?” Because when we get to tax time, sure, there’s different lines for different types of income, but at the end of the day, we’re getting down to: What’s my total taxable income? And the IRS is going to expect you to pay tax based on that.

Benjamin Brandt:         And is some of this sort of based on your own personal desire to dial in that refund? I’m wondering at what point this is just personal preference, I suppose, but at what point would a person want to go and create an online account for social security, or fill out some paperwork where they would want to go back and modify that? Or are you okay just paying, writing a check for $1000 at the end of the year? Is that less painful than going back and doing the paperwork?

Steven Jarvis:     Yeah. Some of it’s definitely personal preference. I work with clients at times who say, “You know what, I’m not giving the IRS an interest free loan. I’m going to hold onto every penny I can, and I’ll write the check at tax time.” But the general rule I try to follow is, as long as you’re not paying underpayment penalties, it really comes down to preference.

Benjamin Brandt:         Right. I guess it is certainly easier to log into Fidelity, or Schwab, or Ameritrade, or whatever that would be, and modify the withholding from your IRA. That’s going to be a lot simpler than contacting your pension, contacting social security, contacting whatever it might be. So there’s a preference there as well.

Steven Jarvis:     Yeah. And especially if you have IRA distributions you know are going to be towards the end of the year, that’s a great time to then take a step back and say, “Okay. Am I on track for the year? And do I just withhold a little bit extra from my next distribution as opposed to having to do an estimated payment?”

Benjamin Brandt:         Sure. Or do a special distribution where you’re doing almost all of it as withholding, whatever your custodian will let you get away with. I think we’ve mentioned that in a previous episode. But of course, you’re going to have to pay taxes on that. So if you’re trying to dial your income in to exactly $100,000 and then do a distribution to pay the taxes, well, you’ve got to add the distribution onto your taxable income as well. Even though it’s all going to Uncle Sam, you still have to claim that as income, so include that in your calculation. But that’s our listener questions for the week. Anything final to add, Steven?

Steven Jarvis:     No, Ben. I think this has been really good. As always, it’s a lot of fun talking to you. And for all of our listeners, until next time, don’t let the tax man hit you where the good Lord split you.

Benjamin Brandt:         We’ll see you next time.