Bunching Deductions to Save on Taxes
Every year the income we must pay taxes on gets reduced by deductions. We either use the standard deduction or itemized deductions, whichever is greater. And we don’t have to pick one and stick with it. One year we can use the standard deduction, and the next year we can itemize. This is perfectly legal. In fact, United States Judge Learned Hand said:
Anyone may arrange his affairs so that his taxes shall be as low as possible; he is not bound to choose that pattern which best pays the treasury. There is not even a patriotic duty to increase one’s taxes.
Since the 2017 Tax Cuts and Jobs Act, most taxpayers use the standard deduction. But for others, the sum of their itemized deductions (mortgage interest, state and local taxes, charitable giving, etc.) are greater than the standard deduction, so they itemize instead.
Then there are a select few—among whom you will soon be able to proudly name yourself—that hop back and forth between the standard deduction and itemized deductions like a flexible tax ninja. In so doing, they save money on their taxes and bring a smile to the face of Judge Learned Hand.
Let’s learn how to bunch our deductions.
First, the building blocks
The first part we need to know is which standard deduction applies to us, because it isn’t the same for every taxpayer. See the table below for the 2020 standard deductions:
These amounts are much higher than they used to be. One of the changes of the TCJA of 2017 was increasing the standard deduction, which greatly reduced the number of taxpayers who itemize their deductions.
The second part to know is which deductions you can itemize. The list below shows common expenses that can and cannot be itemized:
The TCJA also made big changes to itemized deductions. Most notably, there is now a $10,000 cap on state and local tax (SALT) deductions. This means that even if the sum of your property taxes paid and state income or sales taxes paid exceeds that amount, the most you can deduct is $10,000.
Scenario 1 – Mary, a single filer, who typically itemizes every year
Let’s look at Mary’s situation over the next two years.
Mary is a single filer whose income is $75,000. Both years she gives $3,800 away in charitable gifts, she pays $5,000 in mortgage interest and $4,200 in property taxes on the home she owns. Mary has no state income taxes, but she pays $1,000 in sales taxes.
As you can see from the Base Case table below, Mary’s itemized deductions ($14,000) exceed her standard deduction ($12,400), so both years she itemizes.
Now, for the strategy. Let’s assume the exact same facts as above, except this time, Mary is going to bunch her deductions.
First, since property taxes aren’t due until January of the following year, Mary takes advantage of this. For Year 1, she waits until January of Year 2 to pay her property taxes (or she instructs her escrow company to do so), meaning she technically paid Year 1’s property taxes in Year 2. For Year 2’s taxes, she doesn’t wait—she pays the property tax bill in December. To recap, in Year 1 Mary paid $0 in property taxes. In Year 2, she paid $8,400. Mind you, she still paid her property taxes on time both years, she simply changed the timing of when she paid.
Next, charitable giving. All of Mary’s $3,800 in charitable gifts go to her church. For Year 1, she informs her church’s finance team that she still plans to give $3,800 this year, but she’s going to give all of it on January 1st of Year 2. For Year 2, she resumes her regular monthly contributions. To recap, in Year 1 Mary made $0 in charitable gifts. In Year 2, she made $7,600.
For sales tax and mortgage interest, unfortunately, Mary can’t change the timing of when she pays those items, so they remain unchanged. Both years she pays $5,000 in mortgage interest and $1,000 in sales taxes. See below for the side-by-side scenario comparison:
Looking more closely at Scenario 1B, in Year 1 Mary’s itemized deductions total $6,000 (only mortgage interest and sales tax). This is less than the standard deduction of $12,400 so she takes the standard deduction. In Year 2, her itemized deductions total $22,000, which is far greater than the standard deduction, so she itemizes. While it’s true she pays slightly higher taxes in Year 1, the savings in Year 2 more than make up for it:
Scenario 2 – Mary and Joseph, joint filers, who typically take the standard deduction
Let’s see how this changes for joint filers. We’ll imagine Mary and Joseph, her betrothed, finally tie the knot.
Their combined household income increases to $150,000. They double their charitable giving to $7,600, and they move to a larger house with a bigger mortgage, so their property taxes rise to $6,500 and their mortgage interest increases to $7,000. Finally, they spend a bit more, so their sales taxes double to $2,000.
Because Mary and Joseph have a higher standard deduction now ($24,800) than Mary did as a single filer, even with the increased itemized deductions, it still isn’t enough to get them over that high hurdle. So, as you can see below, Mary and Joseph typically take the standard deduction:
Again, for the strategy. Mary and Joseph bunch their deductions to see if they can get over the standard deduction. They deploy the same tactic of timing their property tax payments and charitable giving, delaying those outflows in Year 1, and making them in Year 2.
This scenario represents a great example of a taxpayer who is ideal for bunching their deductions--—when itemized deductions are not quite enough to exceed the standard in one year alone but can exceed the standard if two years can be bunched into one.
However, notice that even though Mary and Joseph’s bunched SALT expenses total $15,000, the cap on SALT deductions of $10,000 prevents this strategy from being even more profitable. Nevertheless, the savings are still meaningful:
Our Take
Certain circumstances can make bunching deductions less favorable, and perhaps not worth the trouble. As seen above, as your SALT deductions approach or exceed $10,000, you benefit less from this strategy. And for some, it may be undesirable for you—or the charity you give to—to bunch your charitable giving. One solution to this last obstacle is to do your charitable giving on the front end. So, you can give Year 2’s charitable gifts in December of Year 1 instead. This allows your charity to have the funds sooner, and you can simply make Year 1 the year you itemize your deductions.
Regardless of your situation, it’s a good idea to investigate if bunching your deductions makes sense. You’re free to “arrange your affairs” as you wish, and if that allows you to save a couple thousand dollars in taxes, it’s well worth it!