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Deduct sales tax or income tax?

The IRS lets you deduct either state income tax or state sales tax from your federal taxes. Most people deduct income tax, but there are times that sales tax is a better choice.

By MSN Money Partner Mar 8, 2012 11:34AM

This post is by Kay Bell at Bankrate.com.

 

Most states and cities get a good portion of their operating revenue from sales taxes tagged onto just about everything you buy. On the federal level, Uncle Sam lets taxpayers use those taxes to help reduce their IRS bills.

 

You can deduct either state income taxes or sales taxes, but not both.

 

The sales tax deduction is particularly welcomed by taxpayers in states that do not collect income taxes but do levy state sales taxes. It also could benefit taxpayers who face substantial local sales taxes. Even some residents of states with both types of taxes might find the sales tax deduction is more valuable to them than the income tax write-off.

 

Most people typically pay more in state income taxes than in state and local sales taxes. But double-check. Depending on your state's income tax rate and how much you made (and paid), your sales tax amount could be greater.

 

Choosing your tax deduction method

 

The process begins with your answers to two filing questions. First, do you plan to itemize? If so, then which write-off -- sales taxes or income taxes -- will give you the biggest break? (Post continues after video.)

The Internal Revenue Service says that most people take the standard deduction. It's easy to claim; there are no forms or work sheets to fill out and each year the standard deduction increases, thanks to inflation adjustments.

 

But if you use the standard deduction, you can't take the sales tax break. To claim the sales taxes you paid, you must itemize.

 

If sales taxes are your only deductible expense, it's not worth it to itemize. This one itemized deduction will likely be much less than your standard deduction, and you always want to take the largest tax deduction amount you're allowed.

 

Taxpayers who itemize expenses will have to decide which option -- deducting sales taxes or income taxes -- will give them the biggest break.

 

Writing off the right amount

 

Then there's the issue of just how much in sales taxes you can claim. If you have the documentation, there is no limit on the deduction amount.

 

Even if you don't have all your receipts, you still might be able to recreate many of your sales tax payments. William Abrams, a partner in the law firm Abrams Garfinkel Margolis Bergson LLP, with offices in California and New York, notes that many types of records, such as credit card statements, are available online. By accessing them, he says, taxpayers could improve the accuracy of their annual sales-tax computations.

 

The actual receipt calculation might be worthwhile if you made a lot of purchases last year. Scenarios involving costly and taxable expenditures include:

  • You bought a lot of electronic equipment.
  • You moved to your first or a new home and furnished it.
  • You bought expensive jewelry, such as an engagement ring.
  • You paid for the wedding that followed that ring purchase.

"You're more likely to have kept receipts for these items for insurance purposes or because they were mind-boggling," says Bob D. Scharin, senior tax analyst from the Tax and Accounting business of Thomson Reuters. "Basically, you're looking for spending that's disproportionate to your income."

 

Most filers, however, will claim the amount that the IRS has figured for them in special sales-tax tables. The deduction amounts are based on the average consumption by taxpayers, taking into account filing status, number of dependents, adjusted gross income and rates of state and local general sales taxation.

 

The IRS tables with standard sales tax deduction amounts can be found in the Schedule A instructions. The IRS also offers an online sales tax deduction calculator.

 

Counting all your income

 

But even with the tables, it's not quite that simple. In using the data, you need to keep a couple of things in mind to get the biggest deduction.

 

First, don't rely solely on your 1040 information when you read the table. The figure you enter on your federal return is taxable income, but Scharin says that the sales tax table amounts are based on total income, not just your adjusted, taxable income. You should take nontaxable income amounts into account for sales tax deduction purposes, he says, because the larger your total income, the larger your sales tax deduction.

 

These other types of income include municipal bond or other tax-exempt interest, workers' compensation, nontaxable combat pay, the nontaxable portion of Social Security and other retirement benefits, as well as the nontaxable parts of an IRA, including a Roth IRA distribution.

 

Also, most of the tables cover only the state rates. "If you have a local sales tax, which many people don't realize, you could be sacrificing some of the deduction if you use only the table amount," says Scharin.

 

To account for local sales taxes, you're going to have to do some extra calculating. If you're not using tax software, a worksheet, also in the Schedule A instructions, will help you determine the correct number.

 

You also could have some extra math to do if you lived in different states that collected sales taxes. In this case, you must determine each state's sales tax amount to arrive at your appropriate, combined deduction.

 

Sales taxes you paid on the purchase of motor vehicles, boats, aircraft and, in some cases, building materials for a substantial addition to or renovation of an existing structure also can be counted on top of your sales tax table and local tax amounts. These additional amounts will be accounted for in the sales tax worksheet.

 

While all these considerations will definitely mean more work for some taxpayers, Scharin says, "If you went this far and you're itemizing, you might as well get your full deduction."


More from Bankrate.com and MSN Money:

 

 

VIDEO ON MSN MONEY

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