Dorothy in Taxland: Above the Line Deductions

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Dorothy in Taxland: Above the Line DeductionsThose with wealth look ahead and adjust their affairs according to the tax code. But, most Americans look backward and only hope that Uncle Sam will return some of what they have already paid. Living in the moment and only looking backward is a recipe for paying the most tax at the worst time.

If you are like most Americans, you filed your tax return in mid-April and did not look at any of it during the last four months. The tax preparation which seemed so valuable at the time has faded like Dorothy’s memories of Oz when she wakes up back in Kansas.

Many people who use tax computation software don’t even understand the changing structure of our country’s tax code. You fill in the blanks, press compute, pay the tax, and then forget about the torture until next year.

Into this dark forest of the tax code we throw college students and recent graduates. It is almost a rite of passage, better likened to a fraternity hazing than a step into adulthood. We smile a little when the trees grab the apples out of their hands.

The obfuscation of the tax code helps hide the details. Its Byzantine rules and regulations are carefully crafted to cover up just how much we pay each year. In other words, tax laws are stupid by design. While you are busy trying to translate word problems written in ‘Taxglish’ you don’t realize they are asking all the wrong questions. Like Dorothy in the field of poppies, you can’t seem to stay awake long enough to realize the danger.

Still, as long as you are so close to the Emerald City, it would be nice to have Glenda send a rain to help you get inside the city’s gates. Similarly, a basic understanding of the specific contours of the stupidity of the tax code can help you avoid meaningless extra payments to the government and keep more of your income.

A professional tax expert can help you get the right deductions, but likely won’t motivate you to keep the right records unless you understand the benefit for yourself.

There are three basic ways to reduce your tax burden: above the line deductions, below the line deductions, and credits. Each of these deductions is used in one of the three general formulas on the 1040 tax form. The first formula is: Gross income minus above the line deductions equals your adjusted gross income (AGI).

All deductions are not created equal. Some deductions are more valuable than others. What matters is whether or not the deduction is “above the line” or “below the line”. The line in this case is your adjusted grow income (AGI).

Above the line deductions are subtracted from your gross income in order to compute your AGI. Therefore, above the line deductions reduce your AGI which also reduces your taxable income. A lot of calculations and limits are computed from your AGI. So, reducing your AGI can lower many subsequent calculations to lower other taxes you may have to pay. As a result, above the line deductions are more advantageous than those taken “below the line.”

Above the line deductions will always lower your taxes. Above the line deductions are rare unless you are self-employed because they are mostly business related expenses. If you are self employed, you should have a lot of above the line deductions you are taking advantage of.

Above the line deductions include everything on Schedule C or F business deductions. If you are not a small business owner, you should consider performing some or all of your work under the umbrella of your own small business. If you run a successful business you will be paid twice what you are currently being paid and find yourself on the yellow brick road of accumulating real wealth. Even if you don’t get any more pay, you may find more of your expenses are tax deductible and therefore you will pay less tax.

If you are not a small business owner there are still above the line deductions you can take such as: stock losses up to $3,000, IRA contributions, student loan interest, moving expenses, alimony and several other items.

Payments to your Health Savings Account (HSA) can also be deducted above the line. In 2007 the limit is $5,650 in tax free contributions. One out of every ten patients consumes 69 percent of health care costs. The other nine would benefit from an HSA.

With the savings on your insurance premiums, you should be able to accumulate a sizeable nest egg. And, unlike your traditional health care plan, your HSA funds are not subject to a “use it or lose it” policy. Anything you don’t spend one year carries over to the next year. After all, it’s your money.

In addition to doctor’s visits, hospitalizations, lab tests and the like, an HSA can also pay for prescriptions and some over the counter drugs like aspirin with pre tax dollars. HSA accounts can even pay for vision and dental expenses such as contact solution and teeth cleanings.

Another above the line deduction is specifically designed for teachers. If you are a qualified educator you can deduct $250 for books, supplies and computer equipment you purchase. This deduction has been extended through 2007 as well.

These deductions are like Dorothy’s ruby slippers, they are adjustments to your income and once adjusted nothing else in the tax code can touch them. Fund your retirement account, start a health savings account and go into business for yourself to take advantage of these incentives in the tax code.

Photo by Megan Marotta

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President, CFP®, AIF®, AAMS®

David John Marotta is the Founder and President of Marotta Wealth Management. He played for the State Department chess team at age 11, graduated from Stanford, taught Computer and Information Science, and still loves math and strategy games. In addition to his financial writing, David is a co-author of The Haunting of Bob Cratchit.