February 27, 2011

Deducting Sales Tax from Your Federal Income Taxes

Currently the IRS allows you to deduct sales tax as an itemized deduction from your taxes in place of a state income tax deduction.   Previously you only had the option of deducting state income tax.   However now if you itemize you can choose to deduct either the sales tax or the state income tax.   You can not deduct both sales tax and state income tax and you have to choose one or the other.  

Only good if you itemize

You can only claim the state sales tax deduction if you itemize your taxes.   If your standard deduction is higher than the total of itemized deductions then you'll pay lower taxes by taking the standard deduction.   You always want to figure it both ways and pick the higher deduction between the standard deduction or itemized deductions.
Should you deduct sales tax or state income tax?

Since you have the choice of sales tax or state income tax you should pick the deduction which is higher.   For many (if not most) states the state income tax paid by individuals is usually higher than the total sales tax paid.    However there are many exceptions where the sales tax paid is more.   If you made a major purchase during the year then you have have an exceptionally large sales tax bill for that year.   Did you buy a new car?   Purchase a boat?  etc.  You'll have to look at your own state income tax bills and your sales taxes to determine which is higher in general for you in your situation.

Often best in states without state income tax

This deduction is especially helpful for people in the eight states without state income taxes.   You probably know who you are but if you live in one of these states then you don't pay state income taxes:

Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, Washington, Wyoming

How to figure the sales tax deduction

There are two ways you can figure your sales tax deduction.   1) you can use the IRS estimator or 2) you can save all your receipts and add up all the sales tax you paid on them.  

1) The IRS sales tax estimator is available online at the IRS website.   The IRS estimator is a simple calculator that will make generic guess on how much sales tax you pay based on your income and ZIP code.   You simply tell the calculator your income, # of exemptions and what ZIP you live in.    You can also tell it the tax paid on specific items including cars, boats, aircraft or mobile homes assuming you pay general sales tax rates on those purchases.   This makes it easy if you know you have a major purchase like a car but didn't keep all the rest of your receipts.

2) To add your receipts manually you first need to save all your receipts through the whole year.    Then you need to go through every single receipt and add up all the sales taxes paid.   This method maybe time consuming and tedious but it might well be worth the effort. 

Is it worth your time to manually add up the taxes?   

This decision may be too late to make now for your 2010 taxes since if you weren't saving your receipts for all of 2010 then you missed that opportunity.  However now is a good time to look ahead to 2011 or future years to decide if saving receipts is worth it.   Saving all your receipts and adding them all up may be a hassle and could take a lot of time.   Problem is that you won't know for sure if its worth your time to add them all up unless you add them all up.   Catch-22 isn't it?    However you could guess if its going to be worth the effort by using the IRS estimator to see what it would say and then making your own estimate of what you actually pay in sales taxes.    To do this you'll have to have a grasp of your sending. If you use budgeting software or track your budget then you can just add up all the taxable columns from last year and get a rough estimate of total spending.  Remember to not count the budget columns that aren't taxed by general sales tax.  

For example in my budget I add up all the columns that you'd pay general sales tax on and I come up with something around $20,000 to $30,000.    Then if my sales tax rate is 9% (for example sake) then that would mean my general sales tax last year was roughly 9% of $20,000-$30,000 or $1,800 to $2,700.    If my income is $100,000 and I plug that into the IRS estimator then it estimates that I'd be paying about $1,500 in taxes.       So I could add up all the receipts myself and claim $1,800 to $2,700 or just use the IRS estimator and claim $1,500 with no extra work.   Therefore the extra work of tracking and adding my receipts would man an extra $300 to $1,200 deduction.   If my federal marginal tax bracket is 25% then that would equate to $75 to $300 in tax savings for my efforts.    Saving all my receipts and manually adding the total sales taxes would probably net me $75 to $300.   Now I think spending a couple hours counting receipts is well worth the time and effort to save $75 or more.   Whether or not manually saving and adding your sales taxes is worth it depends on your individual spending.

How to save and add your receipts

Saving receipts is not too hard, you just shove them in your purse or wallet as you make purchases.   Then on a regular basis like once a week you can dump all your receipts into a box or something to keep them all in one place.  Adding up the receipts is more time consuming, you have to look at each receipt and add the total.  But even if you've got 500+ receipts in a year then that still shouldn't take longer than a few hours time.  I would use a spreadsheet like Excel to add up the numbers.   If you use a simple calculator then eventually you'll goof up and lose track and have to start over.  If you use Excel then all the numbers are in the spreadsheet and you don't have to start over but just fix individual errors.   If you want, it might make more sense to add up your receipts on a monthly basis.    That way you aren't having to face 2+ hours of effort at tax time but break it up into more manageable and less mind numbing 15-20 minute chunks once a month.

How to claim sales tax

Once you know your sales tax total and have decided that its the right deduction to take then claiming it is pretty straight forward.   In order to deduct your sales tax from your federal income taxes you have to itemize your deductions.   Itemizing requires filling out schedule A for your taxes.   You simply check the 5b box for general sales taxes and then write the total sales taxes paid (or the estimated value) into the line 5.

The entire process

1.) This is a preliminary step based on rough estimated numbers.  Determine if itemizing deductions is worth more than standard deduction.   If you know for sure that your standard deduction will be higher than itemized deductions then stop and don't bother trying to deduct sales taxes. If you think you can itemize more deductions than the standard deduction then proceed to step 2.
2.)  This is another preliminary step to see if deducting sales taxes is a good idea.  Compare your state income taxes with your general sales taxes.   If your state income taxes are definitely higher than your general sales taxes then stop and claim the state income taxes instead.   However if you think your sales taxes are generally higher than your state income taxes then proceed to step 3. 
3.) Decide if you want to use the IRS calculator or add your sales taxes manually.   If you want to add them manually then you need to save all your receipts for the year and add up the totals.
4.) Once you've got the total sales tax rate then compare it again to your state income taxes and verify the sales tax is higher.   If sales tax do end up higher then add up your itemized deductions.  If itemized deductions are higher than the standard deduction then claim itemize your taxes and claim the sales taxes on line 5.

Bottom Line:   For some people out there the ability to deduct sales taxes instead of state income taxes on the itemized deductions could be a good tax saver.  

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