If you are like most people, your eyes probably begin to glaze over the second someone starts discussing taxes. Whenever I can’t sleep at night I just grab the Internal Revenue Code and start reading and that usually does the trick. If you suffer from insomnia you should try that some time. I can’t perform a miracle and make taxes sexy and exciting, but I can tell you about a tax planning strategy called “bunching deductions” that may be able to significantly lower your tax liability.
Our current tax code is set up so that most people are given a free tax deduction from the federal government called the “standard deduction.” Think of a deduction as an expense or other write-off that offsets your income and potentially lowers your tax liability.
Here is a highly simplified summary of how federal taxes are calculated for most individuals in the U.S. and where deductions come into play:
x Appropriate Tax Rates
=Tax Liability Before Credits
As you can see, the higher your deductions, the lower your taxable income normally is and the less tax you may have to pay. In other words, deductions = good. More deductions = even better.
Itemized Deductions vs Standard Deduction
If you have certain deductions called “itemized deductions” that exceed your standard deduction, then you can deduct your itemized deductions rather than the lower standard deduction.
Examples of itemized deductions include:
- Charitable contributions
- Real estate taxes
- Mortgage interest
- Medical expenses
- State taxes paid
- Tax preparer fees
- Certain investment fees
However, please keep in mind that certain expenses must exceed various thresholds for them to be deductible. Others may have certain limitations regarding their deductibility.
Many people have itemized deductions each year but not enough to itemize their deductions on their tax return, so those expenses are wasted. Since the standard deduction is higher than their itemized deductions, they choose to use the standard deduction and don’t receive any tax benefit from their itemized deductions.
Other people may have itemized deductions that exceed their standard deduction each year, but just barely. These people may itemize each year, but they still don’t receive that much of a benefit from their itemized deductions since they barely exceed their standard deduction, which they would get anyways.
Bunching deductions could potentially help these people receive more tax benefit from their itemized deductions and lower their tax liability.
Bunching Itemized Deductions
Bunching your itemized deductions is a technique that involves accumulating deductions so that they are high in one year and low the following year, allowing a person to itemize their deductions every other year and use the free standard deduction in the alternate year.
The key to achieving this is to recognize as many of your deductions in the year you itemize as possible, and as few as possible in the year you claim the standard deduction.
Example of Bunching Deductions
Let’s do a very simple example to show you what I mean. Here is the fact pattern:
- James is single and makes $60,000 a year as a computer programmer. He has no other income.
- James gives 10% of his income, or $6,000, to charity annually.
- Charitable contributions are the only deductions James receives.
- For the sake of simplicity, let’s assume that the standard deduction for a single person is $5,000, all his income is taxed at a flat 10%, and other factors such as personal exemptions are ignored.
If James were to faithfully contribute $6,000 a year to charity he would itemize his deductions each year rather than use the lower standard deduction. His taxable income would be $54,000 and his tax liability would be $5,400. Over a 2 year period, he would pay $10,800 in taxes.
Now let’s assume that James talks to his CPA and learns about bunching his deductions. James decides to give it a try.
James decides that he will pay 2 years worth of charitable deductions in year 1 (although it would work if he paid all of them in year 2 as well). In year 1, he pays $12,000 to charity, has taxable income of $48,000 and pays tax of $4,800.
In year 2, he doesn’t make any charitable contributions since he already made them in year 1. He has no itemized deductions, but he does receive the $5,000 standard deduction. His taxable income is $55,000 and his tax liability is $5,500.
Since James bunched his deductions, his total deductions (contributions + standard deduction) increased from $12,000 over the 2 year period to $17,000. His total tax liability over the 2 year period decreased from $10,800 to $10,300. Simply changing the timing of his contributions saved him $500 in taxes!
Most examples will be slightly more complicated than that and total savings will vary by person, but hopefully this helped you understand the concept.
Downsides to Bunching Deductions
It is possible that bunching certain deductions could turn out to actually increase your taxes rather than lower them. For example, if you were to prepay certain taxes or miscellaneous itemized deductions in a year when you had to pay Alternative Minimum Tax you may not receive any tax benefit from doing so.
If you wouldn’t have been in AMT the following year, it may have been more advantageous to not prepay them since you may have received a tax benefit from them the next year.
Additionally, if your bunching strategy involves prepaying a number of expenses, you should make sure you have the cash on hand to be able to do so.
Timing Your Itemized Deductions
You may not have control over the timing of all of your itemized deductions. For example, you probably can’t control the timing of all of the medical expenses you incur. If you come down with severe appendicitis in March, you may not be able to delay your appendectomy until January.
However, some itemized deductions generally give you much more control over timing. Here are a few examples:
- You generally have a lot of flexibility over charitable contributions
- If you make quarterly state income tax payments, you could prepay your Q4 payment in December.
- If you own a home, you may be able to prepay some or all of the following year’s property taxes in the current year.
Not everyone will be able to use this strategy. However, it’s important to know that it exists in case your circumstances change in the future. If this is something that you plan to implement, you’ll likely need to start thinking about it and planning for it well in advance.
Please remember tax planning can be extremely complex and oftentimes involves a number of different factors. If you have questions about bunching your deductions or want to know whether it would be an appropriate strategy for you to implement, please reach out to your tax advisor.
Additional Tax Information
For additional tax information, you might consider the following books:
What are your thoughts regarding bunching deductions? Is it a viable strategy for you given your particular circumstances? Why or why not? Leave a comment below!