[As with anything tax-related, see my disclaimers.]
Reviewing the 2017 changes to the federal income tax laws brought me back to a conversation I had years ago with a coworker, who I’ll call Jason. Jason suggested that alternating between taking the standard deduction and itemizing my deductions could reduce my taxes.
To understand this tax optimization, let’s take a look at an example couple with an adjusted gross income (AGI) of $80k in 2010. Our example couple paid $4.2k in state taxes and had $8k of itemized deductions that they could shift between tax years, for a total itemized deduction of $12.2k, higher than the 2010 MFJ standard deduction of $11.4k. Their annual tax burden is just over $9k, their itemized deduction saving them over $200 in tax. We assume that our example couple’s AGI and deductions keep pace with the standard deduction’s changes for the next 8 years.
Now imagine that our imaginary couple shifts $8k of itemized deductions into every other year, some years having $0 and other years have $16k of additional deductions. This allows them to have a larger itemized deduction on even years and to take the standard deduction on odd years. On years they take the itemized deduction, their tax burden will be drastically smaller and on years that they take the standard deduction, they’ll pay slightly more taxes. But combined together, they’ll pay less taxes overall, around $500/year less on average.
Not every deduction can be shifted to another year. Examples of deductions that cannot be shifted include taxes paid, mortgage interest accrued (mostly), and medical expenses (mostly). Those are stuck in the years that you paid or accrued them.
So what kinds of deductions can be shifted? Charitable contributions can. Jason and I share a religious background that asks for a high charitable contribution. Shifting the charitable deduction amounts to gifting one year’s contribution in a subsequent year.
Mortgage interest is another area where bunching can happen by shifting the December payment into January of the next year. In the years that you want to use the standard deduction, you end up with 11 payments and 13 payments in years you itemize. That’s one months worth of interest that can now be itemized. Others have written about shifting mortgage payments if you want more details on how it works.
Until 2018, I never really had a chance to implement what Jason and I had talked about. Why? Because my state and local taxes combined with my mortgage interest always took us above the standard deduction. We were itemizing every year. I suppose that for a couple of the years I could have shifted deductions to reduce my marginal rates on some years, but after doing the math, it just didn’t seem worth it.
Enter the 2017 tax changes. With my state and local taxes capped at $10k and the increased standard deduction, I’m now able to shift deductions and save on my taxes. Last year, 2019, was an itemize year, and this year, 2020, will be a standard deduction year just like 2018. I shifted my January 2020 mortgage payment into December 2019 and made twice the charitable contribution in 2019 than I normally would.
Looking back on 2018 and 2019, I saved around $300 by shifting my deductions from 2018 into 2019 and taking the standard deduction in 2018. My taxes in 2018 were $2.4k higher but my 2019 taxes were $2.7k lower, compared to itemizing in both years.
Saving $300 in taxes might not seem like a lot, but I expect this to increase as my mortgage interest deduction decreases. If I hadn’t had mortgage interest in both years, I would have likely taken the standard deduction both years, but by bunching my charitable contributions I would have saved $2.4k in taxes.
If I was to imagine an ideal tax law situation, it would be dropping itemized deductions altogether. Essentially this means no more charitable contribution deduction, and I’m okay with that if it meant lower rates to compensate. But until that happens, I’ll continue to look at the tax efficiency of bunching my contributions to maximize the use of the standard deduction.
Have the 2017 tax law changes made you reconsider how you make charitable donations? Have you considered bunching your deductions to take advantage of the increased standard deduction? I’d love to hear about it.