Monday, December 9, 2013

Huge Tax Tip: Bunching Itemized Deductions

As it nears year-end, we thought we'd revamp and re-run this post on bunching itemized deductions.

When your taxes are pretty simple, there aren't oodles and oodles of things you can do to save, but this is a tip that has literally saved my husband and I thousands of dollars (but I have used made up numbers in our example). It 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).

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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, say my husband and I file a joint tax return (which we do), and for 2013 our standard deduction is $12,200 (which it is). Say we donate $12,201 to our church (which is an itemized deduction-- and for purposes of this example, our only itemized deduction. In real life we'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. Lame, right? The benefit is only the amount that we deducted above and beyond the standard deduction (and then multiply that by the tax rate to get your actual savings in $$). Makes sense, right? Because if we hadn't donated a single cent, we still would have gotten to deduct $12,200, which is almost the same thing.

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-- you only get to deduct what you paid in that calendar year). 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. 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? (Flip side is next year if you don't itemize you won't be able to deduct state income taxes paid, so make sure to run the numbers for your personal scenario.) 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 (in our example).

That's great, but... I will be the first to acknowledge that this method does involve some major 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.
  3. Remember, this is not an all or nothing strategy. You can do a partial prepayment. 
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.

Another additional note: Charitable contributions are not the only itemized deductions in the world. Here are some other that you can apply the bunching strategy to:

  • State taxes: This is the amount of taxes paid during the year (if you get a refund, that counts as taxable income). If you're trying to bunch itemized deductions into the current year, consider making a state tax payment early (like your first quarter estimated payment for 2014). Or if you live in a state where you don't have to pay state taxes quarterly, you could make your entire yearly payment in December. Utah falls into this category (TC-40 Instructions, Page 2). 
  • Property taxes: Look into the ramifications of paying your taxes late. If the benefit of paying them late to bunch them into the following tax year outweighs the penalty, consider doing that.

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)?

Let us know -- Questions? Let us know what we should clarify in the comments below.

1 comment:

  1. If you want to keep paying tithing monthly, but take the deduction early, you may want to set up a Donor advised fund - can be done with the Church's philanthropic organization LDS Philanthropies -, via


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