Planning opportunities on a client’s 1040: deductions

In the first post in this three-part Under the Hood series, we explored the financial planning opportunities arising from a client's gross income as listed on IRS Form 1040, lines 7-21. In this installment, we'll continue our discussion with a look at the adjustments from gross income. After determining a client's gross income it is vital to identify all possible deductions.

To the extent this can be achieved, it will reduce the client's income tax liability and allow them to build wealth more rapidly. In this article, we'll look at the available deductions from gross income on lines 23-27. We'll conclude with the rest of the deductions, lines 28-35, in the third and final article in this series.

Deductions from gross income: 1040 Lines 23-27

Line 23: Educator Expenses

All eligible educators may deduct up to $250 of qualified education expenses per year (not adjusted for inflation). If married and filing jointly, each spouse may deduct up to $250 providing both were educators. To clarify, if one spouse incurred $400 and the other incurred $100 of qualified expenses, the maximum deduction would be limited to $350 ($250 + $100). What if the taxpayer has education expenses that exceed this? If they itemize, it may be more beneficial to include these expenses on Form 1040, Schedule A, line 21. However, all items listed on Schedule A, lines 21-23 are only deductible to the extent they exceed 2 percent of the taxpayers AGI. The taxpayer should therefore utilize the option that provides the greatest tax benefit.

What is a qualified education expense? According to the IRS:

Qualified expenses include ordinary and necessary expenses paid in connection with books, supplies, equipment (including computer equipment, software, and services), and other materials used in the classroom.

It should be noted that expenses for home schooling are excluded. In addition, qualified education expenses are reduced by any excludible interest from U.S. series EE and I bond interest listed on Form 8815, plus a few ancillary items. For more information, refer to IRS Publication 529.

Line 24: Certain Business Expenses of Reservists, Performing Artists, and Fee-Basis Government Officials

Deductions listed here are computed on Form 2106 or 2106-EZ. The rules for this can be rather complex. To gain a full appreciation of these rules, a more complete discussion of Form 2106 would be required. In lieu of this, we'll discuss to whom it applies and the deductions included.

Form 2106 applies to fee-basis government officials, qualified performing artists, Armed Forces reservists, ministers and a few others. It includes expenses associated with travel, depreciation of a vehicle (including Sec. 179), expenses connected with the operation of a vehicle, such as mileage, actual expenses, etc., and more. For additional information, please refer to the instructions for Form 2106.

Line 25: Health Savings Account Deduction

The information for this line is derived from IRS Form 8889. The purpose of this form is to:

Report HSA contributions;
Determine the HSA deduction;
Report HSA distributions; and
Figure the amount to include in income and additional tax which may be due.

Who is eligible to establish an HSA account and what are the rules? Taxpayers who are covered under a high deductible health plan (HDHP) that have no other health coverage (except permitted coverage), are eligible for an HSA account. The amount of the annual contribution varies by the type of coverage.

In 2015, those with self-only coverage may contribute up to $3,350 while those with family coverage are allowed to contribute as much as $6,650. Contributions for a particular year can be made by the taxpayer or by another party on behalf of the taxpayer. The deadline for contributions is April 15 of the following year.

To qualify as an HDHP, the deductible must be at least $1,300 for self-only coverage and $2,600 for family coverage. In addition, the maximum out-of-pocket expense is limited to $6,450 for self-only and $12,900 for a family.

To learn more about HSAs, refer to the Treasury Department's Resource Center. Here is a link to get instructions for IRS Form 8889.

Line 26: Moving Expenses

If you moved in connection with your job, and incurred expenses which were unreimbursed, you may be able to deduct them on line 26. The new workplace must be at least 50 miles farther from your home than was your old workplace. If you had no former workplace, the new workplace must be at least 50 miles from your home. Form 3903 is used to determine the amount of a person's moving expense deduction. To learn more, refer to the instructions for Form 3903.

Line 27: Deductible Part of Self-Employment Tax

The information for this line is derived from Schedule SE (long or short form). Schedule SE is used to determine the amount of self-employment tax due and is required if net earnings from self-employment were $400 or greater. If the taxpayer is an ordained, licensed or commissioned minister, a member of a religious order who has not taken a vow of poverty, or a Christian Science practitioner, and has filed Form 4361 which was approved by the IRS, they are exempt from the self-employment tax.

The maximum amount of self-employment tax deductible on line 27 of Form 1040 is 50 percent of the total SE tax due. To clarify, this tax liability includes 12.4 percent of net SE income up to the Social Security wage base maximum of $117,000 (2014). Therefore, the maximum amount of this portion of the SE tax was $14,508 in 2014 ($117,000 x 12.4 percent). In addition, the Medicare tax rate is 2.9 percent of total SE income with no limit. Effective January 1, 2013, an additional 0.9 percent Medicare tax applies to taxpayers with income (SE income or wage income) exceeding the following thresholds.

It should be noted that the additional 0.9 percent tax is the sole responsibility of the employee. To summarize, the maximum deduction for line 27 is 50 percent of the total net SE tax due. Here is a link to more information on Schedule SE.

Conclusion

We have just reviewed the adjustments from gross income from lines 23-27 of IRS Form 1040. As you can see, the rules are complex. However, by gaining a better understanding of them, we should be in a better position to help clients obtain more of the deductions to which they are entitled.

In my next article, the third and final in this series, we'll discuss the remaining deductions from gross income, found on lines 28-35 of Form 1040.