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.