What is a Tax Deduction?: Definition, Examples, Calculation (2024)

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Note:This article is for informational use only and you should consult a tax professional for your specific tax questions.

I’ll admit, taxes aren’t the most exciting thing in the world and I’m saying that as someone currently working in the tax industry. People would rather forget about their taxes until the last minute before April 15th.

Although I am not an accountant or a tax attorney, I am exposed to deals in our firm that help clients with their taxes.

The dull topic of taxes all of the sudden becomes the topic of conversation when we tell clients how they can legally reduce their taxes and pay less to Uncle Sam.

That gets their attention.

It is important to note that tax savings aren’t just for the wealthy. The tax code from the IRS lays out the deductions and credits thatany qualifying person is entitled to.

No one is obligated to pay more taxes than they are legally required to.One way to reduce the amount of taxes you have to pay is with atax deduction.

WHAT IS A TAX DEDUCTION?

A tax deduction is a deduction taxpayers can take to reduce their taxable income amounts,therefore reducing the amount of taxes owed.

Think of a deduction as a subtraction. For example, if you utilize a tax deduction for $2,500 and your taxable income is $50,000, you would subtract that deduction from your taxable income toarrive at your new taxable income of $47,500.

Now you will only be taxed for the amount of $47,500 rather than the $50,000 amount.

Some mistakenly think a tax deductiondirectlylowers the amount of your tax liability.(i.e if you owe $15,000 in taxes, your deduction of $2,500 would trim that down to $12,500).

This is incorrect.This is an example of a tax credit. Tax credits reduce your actual tax bill dollar for dollar, whereas tax deductions only reduce yourtaxable income amount.

Both reduce your taxes in the end, but it is important to point out the distinction.A $2,500 tax deduction and a $2,500 tax credit have different effects on the amount of tax savings you receive.

Opportunities at the Federal and State Level

With taxes, there is the federal tax system and also different tax systems for individual states.

Tax deductions are available at the federal levelandstate levels.

However, the state tax deductions available for one state may differ from that of another state. These will be governed by the state’s unique tax code.Tax codesare written at the federal and state level and provide the details of the rules taxpayers must follow regarding taxes.

Numerous tax deductions are out therebut require a little research on your end to find out what you qualify for.

Legality

Some might think that reducing your taxes is synonymous with evading them. This is not the case.Taking advantage of tax deductions is lawful and no one is entitled to pay more taxes than they are required to.

Online tax filing systems like TurboTax do a great job of helping you identify what tax deductions you qualify for as you are filing them.

The more deductions you can track down and qualify for, the less taxes you will have to pay on April 15th.

EXAMPLES OF THINGS YOU CAN TAKE TAX DEDUCTIONS ON:

• Charitable donations
• Student loan interest
• Medical expenses
• Sales taxes
• Mortgage interest
• Property taxes
• Gambling losses
• Home office expenses
• IRA contributions
• 401(k) contributions

STANDARD VS ITEMIZED DEDUCTIONS

When you file your taxes and elect to use tax deductions, you will havetwooptions:the standard deduction or itemized deduction.

Standard Deduction

Standard deductions are given at the federal level andare often the most hassle-free options for claiming a tax deduction.

It is hassle-free because electing for a standard tax deductiondoesn’t require any math or work on your end and it doesn’t require filling out paperwork or gathering up receipts for all your expenses.

The deduction amount is set and determined already. The standard deduction amountscan change from year to yearand theamount you are entitled to varies depending on your filing status.

Itemized Deductions

Itemized deductions require you to list all the deductions you want to claim one by one.This requires more work from the taxpayer including:

• Identifying what you qualify for
• Tracking down numbers
• Doing the math for the deductions
• Entering in your deductions one by one

While itemized deductions require more effort,that effort can be worth it for the amount of tax savings you can realize.

WHICH IS BETTER? STANDARD OR ITEMIZED DEDUCTIONS?

The better option between standard or itemized deductions will depend ontwofactors:

1. Do you want filing to be quick and easy?
2. Or, do you want to save more money?

With itemized deductions, you have the chance to reduce your taxes by alarger amount if your total itemized deduction amounts exceed the limit of the standard deduction offering.

For 2020, the standard deduction amount for single filers is $12,400.

If you think your total itemized deduction amount will be less than $12,400,you would be better off taking the standard deduction.

If you have a list of deductions you can take that well-exceeds $12,400, putting in the time to itemize your deductions would be more beneficial to youbecause you would be able to reduce your taxable income by a greater amount.

2020 Limits for Standard Deductions

Single –$12,400

Married (Filing Separately) –$12,400

Head of Household –$18,650

Married (Filing Jointly) –$24,800

More Deduction Limits

In addition to total deduction limits,individual tax deductions will often come with limits for the maximum amount you can claim on your tax filings.

For example, if your modified gross adjusted income (MAGI) was less than $70,000 in 2019, you were eligible to take a maximum student loan interest deduction of $2,500.

If your total student loan interest for the year was $4,000, you would not be able to deduct the full $4,000.You would only be able to deduct $2,500.

For 2019, the student loan interest deduction began to phase out once MAGI exceeded $70,000 and fully phased out once MAGI exceeded $85,000.

So if you made more than $85,000 you’re out of luck.

TAX DEDUCTIONS VS TAX CREDITS

We briefly mentioned what a tax credit was earlier in the post. Let’s dive a little deeper into it.

A tax credit is a credit that allows for a dollar-for-dollar reduction of your tax bill.

If your tax bill is $25,000 and you are eligible for a tax credit of $5,000, your final tax bill would be $20,000.

A tax credit and a tax deductionof the same dollar amount have a substantial differencein how they reduce the amount of taxes paid.

Let’s compare the effects of a tax deduction and a tax credit of $20,000 for someone that has an adjusted gross income (AGI) of $200,000.

The total tax bill when using the tax deduction is $54,000, which is $14,000 higher than when using a $20,000 tax credit.

Remember that tax deductionsonly reduce your taxable income amount.

Tax credits of the same amounthave a greater impact on reducing the taxes you paybecause they reduce your tax bill dollar for dollar.

The best thing to do is to maximize BOTH tax credits and tax deductions.

IMPORTANCE TO YOUR PERSONAL FINANCE LIFE

Whether you like it or not, taxes are going to be something you deal with for the rest of your life.

If you are going to pay them,the least you can do for yourself is reduce the amount you are required to pay.You can do this lawfully through tax deductions.

There are hundreds of deductions out there you can claim on federal and state taxes.

Some are more familiar and in plain sight while others require research by you or an experienced accountant or advisor.

This post was for informational purposes only to explain what a tax deduction is and shouldn’t be construed as advice. If you have particular questions on how you can take advantage of tax deductions, consult with a tax professional.

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