Tax Deductions: What Are They, How Do They Work?

A tax deduction is simply an expense that can be subtracted from a taxpayer’s income.  With that said, read to find out what tax deductions are available in the U.S. and how to claim them on tax returns!

Income Tax Returns

In layman’s terms, a tax deduction is an expense that can be subtracted to an income to reduce how much will be paid in taxes. Two of the most common tax deductions are charitable donations and interest expenses. For charitable donations, money donated to charity can be written off to reduce the taxable income by that amount. For example, in a $50,000 income where $1,000 was donated to a charity, the amount can be claimed as a deduction. Therefore, only $49,000 is the taxable income instead of $50,000. From home mortgage interest to retirement plan contributions, there are several tax deductions taxpayers can take advantage of.

According to Ramsey Solutions, there are two ways to claim tax deductions when filling out tax returns. It is either through standard deduction or itemized deduction. The standard deduction is established by the Internal Revenue Service (IRS) every year. If standard deduction is chosen, taxable income is automatically lowered by an amount based on the status of filing (single, married filing jointly, or married filing separately).

On the other hand, an itemized deduction is more complicated. All the tax deductions desired to be claimed must be listed one by one. The Schedule A form must also be filled out with the tax returns where records must be saved to back up the claims. The advantage to this is that itemized deductions lower the taxable income more than the standard deduction.

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Difference Between Tax Deduction and Tax Credit

Simply put, tax deductions lower the taxable income, while tax credit reduces taxes dollar for dollar. This means that a $1,000 tax credit reduces the final tax bill exactly by $1,000. On the other hand, for tax deductions of $1,000 in the 22% tax bracket, only 22% of the $1,000 will be deducted to the taxable income. This means only $220 will be saved.  

Tax credits also have two main categories: the refundable and the nonrefundable. For a refundable tax credit of $500, when a taxpayer owes only $200 in taxes, the IRS will return the $300 in checks. On the other hand, for a nonrefundable tax credit worth $750, even if a taxpayer owes only $250 in taxes, there will not be a return of the $500 in checks, as reported by Ramsey Solutions.

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