What is a Tax Deduction?

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Definition:

A tax deduction allows you to reduce your taxable income, and therefore reduce the amount of income taxes you owe.

🤔 Understanding tax deductions

In the US, federal and state governments levy taxes as a percentage of your taxable income. One way to reduce the amount of taxes you pay is to claim deductions. Deductions reduce your taxable income, meaning taxes apply to less of your total income. Expenses that might be tax-deductible include interest on student loans and charitable donations, among many others. The federal tax code also allows for a standard deduction, which anyone can claim on a tax return instead of itemizing individual deductions. Deductions are different from tax credits, which directly reduce the amount of taxes you owe.

Example

One of the best-known tax deductions is for charitable donations, which you can generally claim up to 60 percent of your adjusted gross income. Suppose you make an annual salary of $35,000. One year, you donate $1,000 to your favorite charity. When it comes time to file your taxes, you can deduct your donation.

This deduction brings your taxable income from $35,000 to $34,000. In other words, you don’t pay taxes on the earnings you donated to charity. Historically, you could only claim this benefit if you itemized deductions (claimed specific deductions one by one rather than the standard deduction). Under the Coronavirus Aid, Relief, and Economic Security (CARES) Act, in 2020 taxpayers can deduct up to $300 in charitable contributions even if they don’t itemize deductions.

Takeaway

A tax deduction is like a coupon for your income taxes…

A coupon for your favorite restaurant might allow you to get one free appetizer if you purchase two entrees. The coupon trims your total bill by reducing the amount of your meal you have to pay for. Similarly, tax deductions reduce your income taxes by reducing the amount of your income that you have to pay taxes on.

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How do tax deductions work?

Simply put, deductions reduce your taxable income, meaning the amount of your income that is subject to income taxes. Here’s how you actually claim deductions, if you’re an employee:

When it’s time to file your tax return, the first thing you’ll need is a W-2 form from your employer. This form shows your wages for the year and how much you’ve already paid in federal income taxes, state income taxes, and payroll taxes.

Next, start filling out Form 1040 either manually or using tax software. You’ll first calculate your adjusted gross income (AGI) using specific adjustments (above-the-line deductions) such as student loan interest and health savings account contributions. After you’ve figured out your AGI, you can begin claiming tax deductions.

You can choose to either claim the standard deduction or itemize your deductions. The standard deduction is a flat amount that almost everyone is eligible for, while itemized deductions are specific ones you can claim instead of the standard deduction.

The term “tax-deductible” refers to expenses you’re allowed to write off as tax deductions to reduce your taxable income. Many expenses may be tax-deductible, from medical costs to state and local taxes.

What is the difference between standardized and itemized deductions?

When it comes to claiming deductions on your tax return, there are two main options: the standard deduction and itemized deductions. Which you use depends on your personal and financial situation.

Standard deductions

The standard deduction is a flat deduction that can reduce your taxable income. There are no special requirements to claim this deduction — It’s available to nearly all taxpayers. Exceptions include married couples filing separately when one spouse has itemized deductions, nonresident aliens, and estates or trusts.

The Tax Cuts and Jobs Act of 2017 nearly doubled the standard deduction amount, while restricting and eliminating some itemized deductions. Following these changes, more people will probably find the standard deduction results in greater tax savings.

The standard deduction you’re eligible for varies slightly depending on your family makeup. Here are the rates for 2020:

  • $12,400 for single filers
  • $24,800 for married couples filing jointly
  • $12,400 for married individuals filing separately
  • $18,650 for heads of household

Blind individuals and those who are age 65 or older are eligible to receive a larger deduction.

Itemized deductions

Rather than claiming the standard deduction, the Internal Revenue Service (IRS) allows you to itemize deductions. This gives you access to a more extensive list of deductions — You can claim whichever applies to you.

There are hundreds of possible tax deductions, including medical expenses, mortgage points (upfront fees people pay to a lender for a better mortgage interest rate), investment interest, and charitable contributions.

The Tax Cuts and Jobs Act restricted the use of many deductions. If you decide to itemize deductions for 2020, be aware that filing your taxes may be a bit more complicated. You’ll also need to provide proof that you incurred expenses to claim those deductions. If you choose to itemize your deductions, you may want to hire an accountant or tax preparer.

Which tax deductions should I use?

You can’t itemize deductions and also claim the standard deduction. So which is the right choice?

It comes down to which option will save you more money. If the sum of your itemized deductions will exceed the standard deduction you’re eligible for, then it probably makes sense to itemize. If the standard deduction is higher, then it may be better to go that route.

If you aren’t sure which will save you more money, you can fill out a draft of your return both ways to see which gives you a larger deduction, then file the winning version.

Suppose you have an adjusted gross income (AGI) of $50,000. You know you qualify for several itemized deductions, but you aren’t sure if they’re worth more than the standard deduction. You decide to fill out a Form 1040 both ways to see which option saves you more money.

Using the standard deduction of $12,400 brings your taxable income down to $37,600. After adding up medical expenses and charitable donations you’re eligible to deduct, you find that your total itemized deductions equal $10,500. Going this route brings your taxable income down to $39,500. In this simplified example, it appears claiming the standard deduction is a better deal.

What can I write off on my taxes in 2020?

There are lots of expenses you can write off on your taxes. Some expenses qualify for itemized deductions, while others are considered “above-the-line deductions,” meaning you can take them even if you’re also claiming the standard deduction.

Itemized deductions

If you’re planning to itemize your deductions, it might be worth talking to a tax pro. That’s because there are hundreds of possible tax deductions available, and you don’t want to miss any. Let’s talk about some of the more popular deductions you might be eligible for:

Medical and dental expenses: Deductible medical expenses include payments you made to doctors, dentists, and other medical professionals for diagnostic, treatment, or preventive medical care. You may be able to deduct expenses you paid for yourself, your spouse, and your dependents. Be aware that only expenses that exceed 7.5 percent of your AGI are eligible for this deduction.

Deductible taxes: You might be able to deduct your non-business state and local income, sales, or property taxes. You cannot deduct all three, though: You can deduct property taxes and either sales or income taxes. There is a $10,000 cap on this deduction.

Home mortgage points: Mortgage points refer to prepaid interest on your home mortgage, which may be deductible.

Interest expenses: Specific types of interest are deductible, including investment interest and qualified mortgage interest. This deduction does not apply to the interest on car loans, credit cards, or other debt.

Charitable contributions: If you donate money to qualified charitable organizations, you can deduct some of that money. You can also deduct the fair market value of items you donate.

Business-related expenses: Some business expenses are deductible as itemized deductions, depending on your relationship to the business. These include business use of your home or car.

Work-related education expenses: If you used your own money to pay for work-related education expenses, you might be able to deduct them. These costs might include fees, books, supplies, and travel. You may only take this deduction if you are self-employed, a performing artist, a fee-based state or local government official, or a disabled individual.

Above-the-line deductions

In addition to itemized deductions, there are several kinds of expenses you can write off even if you opt for the standard deduction. These are known as above-the-line deductions. Here are some examples:

Educator expenses: If you’re an educator and use your personal income to pay for costs related to your job, you may be able to deduct up to $250 of those expenses. Qualified expenses include professional development and books or supplies for the classroom.

Health savings account (HSA) contributions: If you make contributions to an HSA, you may be able to deduct them. Employer contributions and rollovers don’t qualify.

Moving expenses: You can claim this deduction if you’re a member of the active-duty Armed Forces and had to move because of a military order.

Self-employment tax: Self-employed individuals may deduct the employer portion of the amount they paid in self-employment tax (the payroll taxes that self-employed people are responsible for).

Self-employed retirement contributions: Self-employed people may be able to deduct contributions to a retirement plan, such as a SEP individual retirement account (IRA) or SIMPLE IRA.

Self-employed health insurance premiums: Self-employed individuals who pay health insurance premiums for themselves, a spouse, or dependents may be able to deduct those costs.

IRA contributions: It’s not just self-employed people who can claim IRA contributions. If you contribute to a traditional IRA, you may be able to claim this deduction. The amount you can deduct might be reduced if you are covered by an employer-sponsored retirement plan and make more than $65,000 (or $104,000 for a married couple filing jointly). This deduction is not available for contributions to a Roth IRA.

Student loan interest: Most people who make payments on student loans may deduct a portion of the interest they pay up to $2,500.

While itemized deductions come out after you figure out your adjusted gross income (AGI), you use above-the-line deductions to calculate your AGI.

Please note that many complex exceptions and limitations apply, so you may want to consider consulting with a tax advisor before taking any action.

What is the difference between a tax deduction and a tax credit?

A tax deduction reduces the amount of your income that is subject to income taxes. Tax credits, on the other hand, directly reduce the amount of taxes you owe.

Suppose you had $45,000 of taxable income for the year. If you claim a deduction of $1,000, it reduces your taxable income to $44,000. Your income tax rate then applies to your new taxable income of $44,000.

Suppose, on the other hand, that you qualified for a $1,000 tax credit rather than a tax deduction. If your tax bill is $1,500 and you claim that $1,000 tax credit, your new tax bill is $500.

Tax credits can either be refundable or nonrefundable. A refundable tax credit is one that allows you to get a tax refund if the credit you claim exceeds the amount you owe in taxes. A nonrefundable tax credit is one that you can only claim up to the amount you owe.

So if you only owe $500 in taxes and are eligible for a $1,000 nonrefundable tax credit, you can only claim up to $500 of the tax credit.

Some of the most popular tax credits are:

  • The Earned Income Tax Credit, which benefits low to moderate-income individuals and families. To qualify, individuals must earn an income under a particular threshold based on the size of their family.
  • The Child Tax Credit, which provides a credit of up to $2,000 per child for taxpayers who claim at least one child under age 17 as a dependent
  • The Adoption Tax Credit, which benefits people who adopt a child during the tax year
  • The Premium Tax Credit, which is a refundable credit that helps eligible taxpayers with low or moderate incomes pay for the cost of health insurance premiums under the Affordable Care Act

Additional Disclosure: This article contains general tax information and is not legal or tax advice.

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