Taxes

Should I Itemize My Deductions When My Standard Deduction is Higher?

[As with anything tax-related, see my disclaimers.]

Unlike me, my sister is an actual accountant. When I was talking to her about her taxes a few months ago, my ears perked up when she said she was still itemizing deductions on her federal tax return, even though her itemized deductions were less than her standard deduction. 

Huh? I thought the equation was always “Deduction = max(Itemized, Standard)”. I couldn’t understand how it would be an advantage to choose the smaller of the two deduction methods. After all, my home state’s highest marginal tax bracket is 5.75%, much lower than my federal marginal tax rate of 24%. For every dollar that I reduce my taxable income, I save .24 cents of federal tax. Every dollar of increased itemized deductions only saves me .06 cents of state tax. 

In what magical world does it make sense to pay more federal taxes in order to save on my state taxes? Is my home state of Virginia one of those magical places?

Choosing a Smaller Deduction

First, here is my tax situation:

  • 24% federal marginal tax rate
  • 5.75% Virginia marginal tax rate
  • I’m not close to any marginal tax rate boundaries
  • I’m married, filing jointly. In 2020, the federal standard deduction for MFJ was $24,800 and the VA standard deduction for MFJ was $9,000.

My itemized deductions have four main components: state income tax, property taxes, mortgage interest, and charitable deductions. I can’t do much about my state and property taxes, and my ability to influence my mortgage interest deduction is limited to shifting a single mortgage payment between tax years. I can choose when I make charitable contributions, something I regularly do by bunching my charitable donations between tax years.

My state income taxes aren’t deductible in Virginia, but my property tax and mortgage interest together are more than double Virginia’s standard deduction. I’ll come out ahead on my Virginia taxes if I itemize. However, Virginia requires me to use the same deduction method that I used on my federal return.

The following graph shows the relationship between an increasing itemized deduction and the impact on both state and federal taxes. When the yellow line crosses the x-axis, the amount saved on state income taxes equals the extra federal taxes paid by choosing to itemize. For me, the crossover point is $21,746, which is $3,054 less than my federal standard deduction. If my deductions are anywhere in that sweet spot, then it makes sense for me to itemize my deductions.

What If I get Bumped to a Higher Federal Tax Bracket?

I’m not close to a marginal rate boundary, but what if itemizing bumped me into a higher bracket? Would it still be advantageous to itemize when the standard deduction would be higher?

It turns out that yes, it could be. But the window is smaller. For someone in the lower tax brackets, the window is larger. The window for someone in the 32% tax bracket starts at $22,393, while the window for someone in the 12% bracket starts at $19,682. If you know your marginal tax rates, you can use the following equation to determine your window:

$$\dfrac{FederalStandard * FederalTaxRate – \\ StateStandard * StateTaxRate}{FederalTaxRate + StateTaxRate}$$

But I’m Outside That Window. Will Charitable Bunching Help?

Since I’m outside the window, I’m better off taking the highest deduction, either my standard deduction or my itemized deduction. But what if I shifted some of my charitable giving to boost my itemized deduction into that window? Would this be a good way to arbitrage the state and federal standard deductions?

It turns out, not really. Why? By shifting charitable contributions from one year to the next, I’m simply shifting the state tax paid from now into the future, for net zero change. I need to be in the window without shifting my deductions around.

Conclusion

After reviewing my situation, it looks like I’m better off continuing to bunch my contributions to maximize my federal standard of deduction. If I get into the sweet spot of being better off itemizing on my federal to get the state deduction, I’ll take that route.

Anything I’m missing here? Feel free to poke holes in my analysis.

Hasta luego!

2 thoughts on “Should I Itemize My Deductions When My Standard Deduction is Higher?

  1. Don’t forget the 5% implicit marginal rate from the CTC phase out. That would push your MTR from 24% to 29%, like it is for me.

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