In light of the 2018 tax reform, many clients may find the “bunching strategy” advantageous when it may not have benefited them in the past.
This strategy is geared towards taking advantage of certain personal expenses that can be itemized on Schedule A of your tax return. The IRS either gives taxpayers a “standard deduction” ($12,000 for Single, $18,000 for Head of Household, and $24,000 for Married Filing Jointly and Surviving Spouse) to subtract off their “Adjusted Gross Income” (AGI) or, if that taxpayer can prove they had deductible expenses that exceed the standard deduction, they can add them up and take a higher deduction.
These expenses under the new tax law include:
- Medical and dental expenses that exceed 7.5% of your AGI
- State and Local Taxes (“SALT” – income or sales tax, property tax, personal property tax and any other allowable taxes)
- Note: this deduction is now limited to $10,000, even if your combined amount is higher
- Mortgage and HELOC interest
- Note: for house purchases after 12/15/2017, only interest up to the first $750,000 of mortgage debt is deductible
- Charitable Gifts (to the extent they do not exceed 60% of your AGI)
Bunching involves the doubling (or even tripling) of these itemized deductions in one year and then skipping paying those deductible expenses the following year(s). This strategy can be beneficial if your itemized deductions are very close to the standard deduction and you have the ability to “prepay” some of these expenses.
Many people may not have even considered this strategy in the past when the standard deduction was lower due to the fact that their itemized deductions would have exceeded the standard deduction based on items they could not control the timing of (ex. mortgage interest and sales tax). Additionally, if your itemized deductions were limited because of your income, it would not have been a beneficial strategy, since additional deductions would not have been counted.
Let’s look at an example where a married couple incurs the following expenses:
- $2,000 of Sales Tax (given by the IRS based on income and zip code)
- $4,000 of Property Tax
- $7,000 of Mortgage Interest
- $10,000 of Charitable Contributions
These deductions add up to $23,000, which is slightly below the 2018 standard deduction of $24,000 for Married Filing Joint. The couple would not benefit any more by itemizing if they pay those expenses every single year, as the standard deduction exceeds their itemized deductions by $1,000. Over six tax years (assuming everything stayed perfectly consistent with the tax law, phaseouts, and the mortgage interest declining as they paid down the mortgage balance), the couple’s deductions would look like this:
However, if the couple employs the “bunching strategy”, the deductions taken on their tax returns might look like this:
As you can see, this results in an average of $6,200 more in deductions per year ($37,200 more deductions in total), while the true expense still totaled $133,500. Assuming the couple was in the 24% tax bracket, this equates to an extra tax savings of $1,488 per year or $8,928 over six years…simply by timing their payments!
Before you start paying extra on things like property taxes and charitable gifts, you should consult a tax preparer or financial planner to make sure this strategy makes sense for your unique tax situation.