Tax Series #6: You mentioned bunching of itemized deductions—I want in! Tell me how!

This is the last post in our tax series (see rest of series here)! Not going to lie-- as much as we love taxes, Lisa and I were really just trying to power through this tax series so we could build up our reference (read: slightly less exciting) material before we do our first giveaway (as in, before people really start reading our blog).

 

But, this actually is a pretty awesome tax tip, and it has saved my husband and I literally thousands of dollars (but I have used made up numbers in our example). This tip works primarily for people who don't already itemize (typically people who don't have a mortgage) and have large charitable contributions (like tithing, if you're a Mormon).

 

Before we start, it's probably best if you have a little background on how taxes work. I'd suggest checking out this riveting post and also this one (skim if you must) so we're on the same page.

 

All refreshed on how taxes work? Great.

 

So the basic premise is this. If you itemize on your tax return, you're really only getting the benefit from the deductions that are greater than your freebie standard deduction in any given tax year. For example, my husband and I are married (see below)

 

I know it's an unrelated picture, but it's hard to find ways to make a personal finances blog visual-- and a fun fact, I am half Japanese, but our son has BLONDE hair and BLUE eyes-- crazy!

We file a joint tax return, and for 2013 our standard deduction is $12,200. Say we donate $12,201 to our church (which is an itemized deduction-- and for purposes of this example, your only itemized deduction. In real life you'd probably also have some state taxes to deduct, but we're keeping it simple). What benefit did our donation get us? Less than a buck. What a rip, right? The benefit is only the amount that we deducted above and beyond the standard deduction (and then multiply that by the tax rate, of course). Make sense?

 

BUT, because I am a tax nerd, say I convince my husband to prepay our 2014 donation in 2013. So we have our normal 2013 donation of $12,201 plus our 2014 donation of $12,201 that we're going to go ahead and pay early (anytime in 2013 on or before December 31). That means we get to deduct $24,402 this year instead of $12,201 each year. And that means that we get a tax benefit of ($24,402-$12,200)*assumed 25% tax rate. (That's $3,051.) And we're not even touching the state tax benefit. Also, if bunching itemized deductions means you can itemize in a year when you couldn't previously, you'd also get the benefit of deducting your state income taxes paid that tax year. Not bad, eh? Sure, next year we won't have any charitable contributions to deduct, but don't forget that we still get to take the standard deduction, and that is pretty dang close to what we would have gotten itemizing anyway.

 

That's great, but... I will be the first to acknowledge that this method does involve some cash flow management. If you don't have heaps and heaps of cash lying around like this guy, here's a plan that may work for you:

 

  1. Save a portion of your prepayment each month in a savings account set up specifically for your prepayment (set up an automatic transfer, so it actually happens). I use CapitalOne360, but you can choose whom you will.
  2. Make your donation from that account at the end of the year.

Additional note: If you went ahead and just prepaid your donation out of savings you had, make sure that you replenish your savings throughout the year. For example, typically we donate to our church on a monthly basis. When we prepay our tithing (say we prepaid 2013's tithing in 2012), then each month in 2013, we set up an automatic transfer to our savings for the amount that we normally would have sent to our church. That way we make sure that we don't "fritter away" the money. If you went ahead and did steps 1 and 2 above, you wouldn't need to bother with this.

 

And as a final, additional note: This tip is a bit advanced, because (A) it can involve high $$ amounts, and (B) it involves calculating what your tax would be under a couple of different scenarios. You really need to run the numbers both ways to make sure it makes sense for you (and this requires a pretty decent understanding of how taxes work). So don't do it until it really makes full and complete sense to you. 

 

Speak up -- What other tax areas would you like to hear more about (if any)?



Tell it plain -- Do you think you would ever use this strategy? Would you like us to walk through a few more examples of how to run this strategy?

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