Tax Deductions

How These Tax Breaks Can Lower Your IRS Bill

Tax deductions are a type of tax break that helps reduce your income tax balance. They are slightly different than tax credits, and there are several kinds of tax deductions available.

Tax Deductions vs. Tax Credits

It’s important to note the difference between a tax deduction and a tax credit. While both can help lower your taxes, they are calculated differently.

Tax deductions lower your taxable income and they are equal to the percentage of your marginal tax bracket. For instance, if you are in the 25% tax bracket, a $1,000 deduction saves you $250 in tax (0.25 x $1,000 = $250).

On the other hand, tax credits provide a dollar-for dollar reduction of your income tax liability. For instance, a $1,000 tax credit actually saves you $1,000 in taxes.

A tax credit is always worth more than a dollar-equivalent tax deduction, because deductions are calculated using percentages. Referring to the numbers above, you can see that a $1,000 credit offers $750 more in savings than a $1,000 deduction.

Types of Tax Deductions

There are two main types of tax deductions: the standard deduction and itemized deductions. A taxpayer must use one or the other, but you cannot claim both types. It is generally recommended that you itemize deductions if their total saves you more money than the standard deduction.

The standard deduction is a dollar amount that reduces your taxable income. It is usually adjusted for inflation every year. Your standard tax deduction amount is based on your filing status and it is subtracted from your AGI (adjusted gross income).

If you do not qualify for the standard tax deduction, you may choose to itemize your deductions. A taxpayer will also typically itemize tax deductions if it offers them more benefits than the standard deduction (i.e., when the total amount of qualified deductible expenses is greater than the standard deduction). Certain itemized deductions are based on a minimum (or “floor) amount. This means that you can only deduct amounts that exceed the specified “floor.” There is also an income limit for taxpayers who itemize.

Alternatively, “above-the-line deductions” are taken before your AGI is calculated (instead of after, like the other tax deductions). Above-the-line deductions are subtracted from your gross income, and the resulting number is your AGI. Above-the-line tax deductions apply whether you itemize or not.

It’s in your best interest to take advantage of every tax credit and deduction available to you. Understanding your financial position together with your personal situation will help you determine which tax credits and tax deductions you can benefit from.

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