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In the immortal words of Jerry Seinfeld: “You don’t even know what a write-off is.”
Fans of the ‘90s sitcoms will of course reply: “Do you?”
Unlike Jerry, yes, I do.
A write-off is an incredibly misleading nickname for an expense that can help lower your taxable income. It is not a magic trick that suddenly makes something free. The term the IRS uses is tax deduction. While those terms are often used interchangeably, great financial advisors know there is an important difference. That difference is how taxpayers, your clients, react to them.
I have worked with enough taxpayers (and advisors) to know that saying “write off” versus “tax deduction” elicits very different emotions. That is not to say that a tax deduction is universally understood. But something being deductible is rarely confused with being free, as is commonly the case when taxpayers talk about write offs. Using the right terminology helps a taxpayer take a more intentional and informed approach. It is an important step in helping your clients understand how to reduce their taxable income.
What is deductible?
Like all tax-related questions, the answer starts with: “it depends.” You might be thinking, “But wait, there are some things that are always deductible.” But there is more to it than just what someone spent their money on. For individuals, especially those who make most of their money from employment, almost nothing is tax deductible. With the Tax Cuts and Jobs Act in 2017, the standard deduction increased to a level that 90% of American taxpayers don’t get a deduction for any of their expenses.
For 2022, the standard deduction for a married couple filing jointly is $25,900. If a couple pays $10,000 in mortgage interest, one of the more commonly recognized deductions for taxpayers, none of it is deductible because it is less than the standard deduction amount. By default, if the couple has $100,000 in income, it will be reduced by $25,900 to $74,100, with no additional benefit for having paid mortgage interest.
If they also have $10,000 in state and local taxes, now they are up to $20,000 in potential deductions, but still are receiving $0 in tax benefits. They are in the same tax situation as a similar couple with $100,000 in income but no mortgage interest or state and local taxes. While the outcome is the same, it is critical to understand the difference to know what planning opportunities might be available in the current or future years.
Even if we assume that in addition to $10,000 of mortgage interest and $10,000 of state and local taxes, the couple also gave $10,000 to qualified charities, they still have not received $30,000 in tax benefits. Since they would have received the standard deduction regardless of their spending, the only benefit is the amount in excess of the standard deduction. Their $30,000 in “deductible expenses” only reduces their taxable income by $4,100, and that’s assuming no other phase-outs or limitations apply.
But I own a business, that changes everything
The opportunities for tax deductions do increase for business owners, but caution is still prudent. Misunderstandings on this topic make for great TV, but are frequently a little too close to reality. Even when something is deductible for tax purposes, referring to it as a write off has the tendency to make people think about the expense as free, and that’s just not how it works.
According to the IRS, an expense has to be both ordinary and necessary to be deductible. This means that just because you put it on your company credit card you don’t automatically get to pay less in taxes. Especially for business owners, getting caught up in something being a write off can be detrimental. Cash is still going out the door to pay for the expense. Even if a smashed-up radio can be written off, that doesn’t magically make the money reappear.
For business owners and advisors who work with them, tracking expenses and taking full advantage of tax deductions is incredibly valuable. None of this is to say that expenses shouldn’t be tracked and reported. Business owners should have an intentional process for making sure they are getting a tax benefit for the expenses of their business wherever possible. But having “tax write off” as the primary reason for doing something is not a winning formula.
Tax deductible is a bonus, not the reason to do something
One way to explain this to clients is that, “Taxes are an important passenger on the bus, but we never let them drive.” This holds true for all areas of tax planning, including whether to spend money on things that are tax deductible. No one has ever come out ahead paying for things they otherwise have no need for, just to get a tax deduction. Giving $10,000 to a charity you don’t support to maybe save $2,000 - $3,000 in taxes is terrible planning. Buying supplies your business will never use because you can “write them off” will never get you ahead.
There are no patriotic awards for overpaying the IRS. Effective tax planning is a great way to help clients on their financial journey. The words we use in discussing planning opportunities with our clients helps shape the behaviors and outcomes they can expect. The best financial advisors are intentional about how they describe opportunities to their clients and practice their wordings to make sure they are delivering massive value through the process.
Happy tax planning!
Steven A. Jarvis, CPA, MBA, is CEO and head CPA of Retirement Tax Services.
Read more articles by Steven Jarvis
Advisor Perspectives welcomes guest contributions. The views presented here do not necessarily represent those of Advisor Perspectives.
