What Is a Tax Deduction and How Does It Work?
A tax deduction lets you subtract certain expenses from your income before you file taxes. You are then taxed on this lower amount of income instead of the amount you actually earned.
The government allows deductions for expenses that are seen as benefiting the economy or the common good. For instance, tax deductions may encourage people to buy homes or to save money by subtracting some of those expenses from your taxable income.
The benefit for you is that tax deductions can save you money when it comes to paying your personal taxes.
Tax Deduction vs. Tax Credit vs. Tax Exemption
Tax deductions are one of three main types of individual income tax incentives — the other two are tax credits and tax exemptions.
Tax incentives are government policies that attempt to get taxpayers to spend money, save money or encourage a particular behavior that benefits the country’s economy by reducing their tax bill. Tax deductions, tax credits and tax exemptions do this in different ways. Understanding the differences between them and how each may apply to you can help you get the most out of your personal finances.
- Tax deductions
- Tax deductions reduce the amount of your income that is actually taxed. Deductions, for example, let you subtract how much you spent on interest payments on your mortgage or how much you contributed to qualified retirement plans. These two deductions encourage home ownership and retirement savings — both are things the government sees as beneficial to the economy.
- Tax credits
- A tax credit is a specific dollar amount reduction in your tax bill. You subtract this dollar amount from your tax bill. Instead of reducing the amount of your income that’s taxed, a tax credit reduces how much you owe. An example is the Earned Income Tax Credit (EITC). The EITC benefits low wage workers, by reducing their tax bill or even returning them money. The goal is that this will encourage single parents to participate in the workforce.
- Tax exemptions
- A tax exemption either reduces or eliminates your requirement to pay taxes. Personal exemptions were done away with in the 2017 Tax Cuts and Jobs Act and will be gone until at least 2025 and existing exemptions overlap with certain tax deductions — both reduce your taxable income. Income from unemployment compensation or municipal bond may be tax exempt.
Differences Between Tax Incentives
Standard Deduction vs. Itemized Deductions
Your income, filing status and amount of potential deductions determine whether you should claim the standard deduction or itemize deductions when filing your income tax return. You have to choose one route or the other — you cannot choose both.
The standard deduction is a specific amount determined by the government based on your filing status. The amount varies based on your filing status and is adjusted each year.
|Filing Status||2022 Tax Year||2023 Tax Year|
|Married filing separately||$12,950||$13,850|
|Married filing jointly||$25,900||$27,700|
|Head of household||$19,400||$20,800|
The standard deduction is also higher for taxpayers who are 65 or older and for blind taxpayers.
Even if you have no other deductions or tax credits, you can claim the standard deduction. But taking the standard deduction means that you cannot claim other deductions.
Itemizing deductions is more involved. Not every dollar you spent on qualified deductions can be subtracted from your income to lower your tax bill. Sometimes there’s a cap on how much you can deduct.
Itemizing also requires that you keep records of your qualifying deductions throughout the year, fill out more tax paperwork and preserve all these records in case you’re audited in the future.
Read More: Federal Tax Brackets
Types of Itemized Tax Deductions
The Internal Revenue Service determines what qualifies as an itemized deduction — and the IRS may also cap how much of your expenses you can claim.
There are several qualified expenses that you can itemize, but you must be able to show records for the expenses you are claiming as deductions.
- Mortgage interest deduction
- You can deduct the interest you pay on your mortgage — up to a point. If you took out a mortgage after Dec. 15, 2017, the mortgage interest deduction is limited to interest on $750,000 of mortgage debt.
- Charitable contributions
- You can deduct your gifts to charity up to 60 percent of your adjusted gross income — your gross income after it’s adjusted for certain deductions.
- IRA contributions deduction
- Your contributions to a traditional IRA are deductible. Contributions to a Roth IRA are not. The maximum amount you can contribute to an IRA in a single year is $6,500 — or an additional $1,000 if you are 50 or older.
- Medical expense deduction
- You can only deduct qualified, unreimbursed medical expenses that are more than 7.5% of your adjusted gross income (AGI) as of 2022.
- State, local and property tax deduction
- The 2017 Tax Cuts and Jobs Act limits the deductions you can make for state and local taxes – including income and property taxes. You can only deduct a total of $10,000 collectively. It’s only $5,000 total if you are married filing separately.
- Real estate expense deduction
- You can deduct premiums for your mortgage insurance and real estate taxes on your home for the year.
- Student loan interest deduction
- The maximum student loan interest deduction is $2,500. But you can’t claim the deduction if your adjusted gross income is over $80,000 — or $165,000 and married filing jointly.
Seven of the Most Common Itemized Tax Deductions
There are other, less common tax deductions such as personal property tax deductions or sales tax on certain qualified purchases. Moving and business related expenses may qualify for deductions in certain cases.
You should also check with your state tax agency to find out what state or local tax deductions you may qualify for when filing your state income tax return.
A tax professional or tax preparation software can help you find these less common deductions.
Pre-tax deductions are money taken out of your wages or salary before you get your paycheck. These can include payroll taxes and qualified health and retirement plans. Rules for what qualifies as a pre-tax deduction may change from year-to-year based on changes to federal tax law.
Examples of Pre-Tax Deductions
- 401(k) or other retirement plan
- Commuter benefits
- Dental insurance
- Flexible spending accounts (FSA)
- Health insurance
- Health savings account (HSA)
- Life insurance
- Long-term and short-term disability insurance
- Supplemental insurance coverage
- Tax-deferred investments
- Vision benefits
Source: Bamboo HR
Pre-tax deductions in these cases allow you to pay for your share of these employer-sponsored benefits before your money is taxed. At the same time, most benefits have limits on how much you can contribute in a given year to prevent you from running up the amount of your pre-tax deductions.
How to Calculate Tax Deductions
Calculating your tax deductions can determine if it’s better to take the standard deduction or itemize each individual deduction for which you qualify. You want to choose the option that saves you the most money.
There are several ways to calculate whether the standard deduction or itemized deduction is better for you. No matter what method you choose to find your best option, you will need several different records before you start.
Records Needed to Calculate Tax Deductions
You will need your most recent pay stub to determine
- Most recent pay period income
- Year-to-date income
- Year-to-date federal income tax paid
- State and local income taxes paid
- 401(k) or other employer sponsored retirement plan
- HSA, FSA or other cafeteria plan contributions
You will also need records showing other sources of income, including
- Scholarship or grants
- Unemployment compensation
- Self-employment income
- Investment income
- Estimated tax payments
- All other forms of taxable income
- Student loan interest paid (capped at $2,500)
- Educator expenses (capped at $250)
- IRA contributions not deducted from your paycheck
Lastly, you will need records for other deductions for which you may qualify, such as
- Medical and dental expenses
- Taxes you have already paid
- Qualified interests you have paid (such as student loan or mortgage interest)
- Charitable contributions
- Casualty losses
Determining Whether to Itemize or Take the Standard Deduction
A professional tax preparer can calculate which route is the better one for you. Tax preparation software can also walk you through the steps to calculate your tax deduction options.
Another quick way to figure out if you should take the standard deduction or itemize your deductions is to simply add up the items that would result in the largest deduction.
These are typically the mortgage interest deduction, charitable donations and state and local tax deductions. But you are capped at claiming no more than $10,000 in deductions on state and local taxes — including state and local income taxes and property taxes.
Usually, if adding up these larger deductions don’t come close to the standard deduction, you’re probably going to have to claim the standard deduction.
Ideally, you want to choose the option — the standard deduction or itemized deductions — that saves you the most money on taxes. Once you’ve calculated your itemized deductions and compared them to the standard deduction, you’ll know which to claim.