A tax deduction is a type of tax benefit, like a tax credit or exemption, that could help reduce the taxes you owe.
Every tax season, as we all prepare to file our tax returns, tax payers have to think about things like what tax deductions, tax credits, or tax exemptions might apply to them. All of these are considered tax benefits that can help ease your tax liability in some way. But they each work in a different way and come with different qualifications for tax filers.
This article will go over what a tax deduction is, how it works, and the different types of tax deductions that could apply to you. If you think you might be eligible for a deduction this year, keep reading so you can learn how it all works.
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Key Takeaways:
- Learn the answer to what is a tax deduction?
- Understand how tax deductions work
- Learn about the 5 different types of tax deductions
- Find out which tax deductions could apply to you
What is a Tax Deduction?
A tax deduction is a reduction in the amount of taxable income before calculating taxes. The term tax deductible is used to describe an expense that can be subtracted from taxable income to reduce the amount of tax owed.
A common example of a tax deduction will be an expense that can be subtracted from a tax filer’s overall taxable income. A few different kinds of expenses can potentially qualify like donations, interest payments, and business expenses.
By subtracting this expense from your taxable income, your overall taxable income decreases in amount. With less income being taxed, you’ll end up paying less in taxes with these tax benefits applied.
In simple terms, this is the essence of how this tax benefit works. But there is more to it than this. Tax filers will also need to consider things like their tax bracket and whether their exact expenses truly qualify.
Keep reading to learn more about how this tax break works and which types of tax deductions could work for you.
How Do Tax Deductions Work?
The way that tax deductions work is by reducing your taxable income. This reduces the amount of your income that is being taxed. By reducing the amount of your income being taxed, how much you end up paying in taxes is also reduced.
These reductions in the income that can be taxed come directly from certain expenses. Specific expenses can qualify to be subtracted from your amount of taxable income like donations you made, interest you paid on things like your mortgage, or maybe business expenses you personally had to pay.
The process for an individual to apply tax deductions to their tax return might look like this:
Step 1: Determine that you have eligible expenses that qualify as tax deductions.
Step 2: On your 1040 tax form, or a 1040 schedule form, outline the deductions you wish to apply to your tax return following the instructions on the form closely.
Step 3: Include supporting documentation like receipts for these expenses in your submitted tax return.
An example of how tax deductions work is if someone had a total annual income of $50,000, but they had a qualifying expense that was $5,000. By subtracting this qualifying expense from your total annual income, this tax filer’s total taxable income is now $45,000 instead of $50,000. By reducing your taxable annual income in this way, the tax filer can now be taxed on less of their income for that year.
It’s important to remember that there are also different kinds of tax deduction options available to tax filers. An itemized deduction like the example we just gave might be a great option for you and provide great tax benefits, but a standard deduction could potentially provide more benefits.
Which tax deduction to choose depends on many factors, and you want to make sure you do this right so you can avoid any tax audits. Let’s go over the different kinds of tax deductions there are to see which one is best for you.
Different Types of Tax Deductions
There are many different types of tax deductions but the primary and most common ones are the standard deduction and itemized deduction. Which ones you can use on your tax forms can depend on things like your tax jurisdiction, the state you’re in, your personal eligibility, and requirements on the deduction itself.
Standard Deduction
The standard deduction is a type of tax deduction that subtracts a fixed amount set by the government from a tax filer’s taxable income.
Most all individual tax filers can qualify for the standard deduction, but you cannot choose the standard deduction and the itemized deduction. You can only choose one.
Itemized Deduction
The itemized deduction is a type of tax deduction that subtracts qualifying expenses from a tax filer’s taxable income.
These qualifying expenses could include mortgage interest, medical expenses, dental expenses, charitable donations, and in some cases even state and local income tax expenses.
Above-the-Line Deduction
The above-the-line deduction, or the adjustments to income deduction, is a type of tax deduction that subtracts specific expenses from a tax filer’s taxable income even if they didn’t choose an itemized deduction. These expenses include student loan interest payments, self-employement tax, and contributions to some types of retirement accounts.
Business Expenses Deduction
The business expenses deduction is a type of itemized deduction that subtracts business expenses and self-employement expenses from a tax filer’s taxable income. Examples of business expenses or self-employment expenses that could qualify include the costs of running a business, rent, utilities, supplies, employee pay, home office, health insurance premiums, etc.
Capital Losses Deduction
The capital losses deduction is a type of tax deduction that subtracts monetary losses from investments or property sales from a tax filer’s taxable income.
