With big changes to federal tax law starting in 2018, bunching deductions may become an especially valuable concept for you to utilize as a way to reduce your taxes.
At its most basic level, figuring your income tax is simple. You add up all of your income for the year, and then you subtract your allowable “deductions” to arrive at your taxable income. The amount of tax you owe is then calculated by multiplying your taxable income times the tax rate or rates that apply for that amount of taxable income.
To reduce the amount of tax you pay, you want to subtract as many deductions as possible from your income to make your taxable income as small as possible. Almost everyone is familiar with this idea of claiming “tax deductions.”
Tax rules include a built-in amount of deduction called the “standard deduction,” which automatically reduces taxable income by a set amount. This deduction may be used even if you don’t otherwise have any allowable tax deductions. The new federal tax law for 2018 increased standard deduction amounts significantly, which, combined with lower tax rates in the new law, will result in many people paying lower taxes. The new standard deduction amounts are shown in the table below:
2018 Standard Deductions
Type of Taxpayer 2018 Tax Law Prior Tax Law
Single $12,000 $6,350
Married filing jointly $24,000 $13,000
Head of household $18,000 $9,550
Taxpayers also have the option of listing out, or “itemizing,” their allowable deductions and using the total of their itemized deductions instead of the standard deduction if their itemized deduction amount is greater than the standard deduction. Using a larger total of itemized deductions would reduce their taxable income more than using the smaller standard deduction.
In past years, itemized deductions included deductions such as state and local income tax, property tax, mortgage interest, medical expenses, charitable contributions, tax preparation fees, home office expenses, and others. Under the new tax law for 2018, though, many itemized deductions have been capped, reduced, or eliminated. For example, the deduction for state and local income and property tax is now limited to a total of $10,000. The mortgage interest deduction is now limited to interest paid on the first $750,000 of your home loan for new home loans acquired after December 15, 2017. Interest on home equity loans is no longer deductible.
The group of so-called “miscellaneous itemized deductions”—for things such as tax preparation fees, investment advisor fees, home office expenses, and unreimbursed employee business expenses—has been eliminated. (It’s important to be aware, though, that individual states have not yet adopted the changes from the new federal tax law into their own state tax law. So be sure to continue keeping track of your expenses that were deductible under the prior federal tax law because those expenses may still be deductible for state income tax purposes.)
With higher standard deduction amounts and fewer available itemized deductions in 2018, it may be harder for you to get over the standard deduction threshold to make use of itemized deductions. For example, a married couple with itemized deductions totaling $23,000 in 2017 benefited from using itemized deductions; their itemized deductions were $10,000 greater than the $13,000 standard deduction and resulted in less taxable income for them. But if they have the same $23,000 total itemized deductions in 2018, they will now benefit more from using the $24,000 standard deduction because it is $1,000 more than their itemized deductions and results in lower taxable income.
Now let’s take a look at how bunching might affect this same couple’s income tax. Suppose that their itemized deductions include $3,000 of charitable donations during the year. With the higher standard deduction, they effectively get no tax benefit from their donations because their total itemized deductions, including charitable donations, were under the standard deduction threshold of $24,000. Yet if the couple instead bunched their charitable donations into different years—for example, giving $6,000 every two years instead of $3,000 every year—they would get tax benefit from their donations.
In years when they didn’t give, they could still use the standard deduction. And in years when they did give, their itemized deductions would then exceed the standard deduction. In a giving year, their itemized deductions would be $26,000, which is $2,000 higher than the $24,000 standard deduction and so would reduce their taxable income in that year. Bunching deductions every two years reduces their tax bill. And if the couple still wanted to give each year, they could use a donor-advised fund for their charitable contributions as discussed in this article.
While this example centers on bunching deductions offered for charitable donations, bunching is a general concept that applies to any deductions you may be eligible for. The idea is simply to group together deductions that you may have otherwise spread over multiple years, packing them into a single year to push that year’s itemized deductions above the standard deduction threshold.
Bunching can be used with any deductions for which you have control over timing. Medical expenses for elective procedures is another area where you may be able to do this. (However, medical expenses come with their own limitations, being deductible only once they exceed 7.5% of your income in 2018 and 10% of your income in 2019 through 2025.)
While deduction bunching isn’t hard to understand, this multi-year tax planning technique does require some thought ahead of time. Consider reviewing your tax situation early enough in the year to best take advantage of this approach over the next several years.