Tax Deductions

What is a Tax Deduction?

If something is “tax deductible,” it means that you can subtract the value of that item from your taxable income.

A tax deduction, therefore, reduces the amount of taxes you owe but not dollar for dollar.

Deductible Items Include:

  • Business expenses
  • Educational expenses
  • Medical expenses
  • Retirement plan contributions
  • Charitable donations
  • Standard Deduction (discussed below)

How Much You Pay in Taxes

A tax deduction does not directly reduce your tax bill. For example, if you owed $2,000 in taxes but made a charitable donation of $500, your tax bill is not reduced to $1,500.

Tax deductions also do not reduce your tax rate. Instead, tax deductions reduce the amount of income you have to pay taxes on, which results in a lower total tax bill.

Example: No Deduction

Annual Income: $45,000

Filing Status: Single

Marginal Tax Rate: 25%

*For simplicity, assume no deductions*

Total Taxable Income = $45,000

Income Tax Due According to 2017 Income Tax Brackets

The first $9,325 is taxed at 10% = $932.50

The next $28,625 is taxed at 15% = $4,293.75

The final $7,050 is taxed at 25% = $1,762.50

Total Income Taxed = $9,325 + $28,625 + $7,050 = $45,000

Total Income Tax Bill = $932.50 +$4,293.75 + $1,762.50 = $6,988.75

Example: Charitable Deduction

Tax Deductible Charitable Donation: $5,000

Total Taxable Income = $45,000 – $5,000 = $40,000

Income Tax Due According to 2017 Income Tax Brackets

The first $9,325 is taxed at 10% = $932.50

The next $28,625 is taxed at 15% = $4,293.75

The final $2,050 is taxed at 25% = $512.50

Total Income Taxed = $9,325 + $28,625 + $2,050 = $40,000

Total Income Tax Bill = $932.50 +$4,293.75 + $512.50 = $5,738.75

Because of your donation to charity, you saved $1,250 in taxes.

Easy Deduction Calculation

If you just want to know how much a given deduction will save you and not how much tax you’ll actually owe, simply multiply the value of the deduction by your marginal tax rate. In the example above, the $5,000 charitable donation saved you $1,250, or $5,000 * 25%.

If you are on the cusp of two different tax brackets (for example, if you earned $38,000 in 2017 you’d just barely be in the 25% bracket), use the next lowest bracket for this calculation to get the most accurate result.

Itemized vs Standard Deductions

The IRS provides a standard deduction that anyone can apply to their taxable income. It generally increases over time to account for changes in the cost of living.

Some people, however, qualify for larger deductions either because they made charitable contributions, paid interest on a mortgage, had business expenses, or qualify for other “itemized deductions.”

You cannot claim both the standard deduction and itemized deductions. You have to choose. If you have itemized deductions, add them up to see if they are greater than the standard deduction allowable for your filing status. If not, stick with the standard deduction.

Tax Deductions vs Credits

Deductions aren’t the only way to reduce your tax bill, but it is important to understand the difference between tax deductions and tax credits.

Deduction—Lowers your taxable income, which results in a lower tax bill, but is not a direct reduction. If your tax deductions add up to more than your taxable income, you could receive a tax refund.

Credit—Directly reduces your tax bill dollar for dollar. If you owe $1,000 in taxes and receive a $200 tax credit, your tax bill is reduced to $800. A tax credit, however, cannot reduce your income tax to below zero. In general, you cannot use tax credits to produce a tax refund, with some exceptions.

Tax Benefits for a College Student

Paying for a college education is never fun, but it can offer some important tax breaks.

To take advantage of these tax benifits, you don’t even have to be the one in school. If you pay for the educational expenses of your spouse or your dependent, you can still qualify if you meet certain criteria.

  • Student Loan Interest Deduction
    • Maximum: $2,500 per year
  • Tuition and Fees Deduction
    • Maximum: $4,000 per year

Some very lucrative tax credits are also available for students, so always make sure you are aware of all the benefits you qualify for. In some cases, you may have to choose between taking a tax credit or tax deduction for certain expenses. If you qualify for both, choose the one that reduces your tax bill the most.

Medical and Dental Deductions

You can also claim a tax deduction for any qualifying medical or dental expenses that exceed 10% of your Adjusted Gross Income (AGI).

So, if your AGI is $45,000, you can only deduct medical expenses that exceed $4,500. This deduction is most useful for people who are lower income, have very high insurance premiums, require regular medical care, need expensive medications, or require surgery.

You have to itemize deductions to claim your medical expenses. If you claim the standard deduction, your qualifying medical expenses cannot be deducted.

Dependents

In some cases, you can claim deductions for expenses paid on behalf of someone else, who is called a “dependent.” Although most of the tax benefits of claiming dependents come in the form of tax credits, not deductions, you may be able to deduct educational or medical expenses that you pay for someone else.

The most commonly claimed dependents are:

  • Spouses
  • Children
  • Elderly parents
  • Significant others or nonrelatives if:
    • They live with you
    • They earn less than $4,000 per year
    • You pay at least 50% of their expenses

You cannot claim someone as a dependent if they file their own taxes or are being claimed by someone else.

Retirement Savings Deduction

If you contribute to a traditional retirement savings account, such as a 401(k) or IRA, you can deduct the amount of your contributions from your taxable income.

For example, if you earn $45,000 annually but you contribute $10,000 to your employer-sponsored 401(k), you only have to pay income taxes on $35,000.

If you have a Roth account, however, you must pay income taxes on all your income in the year you earn it.

Business Expense Deduction

It requires meticulous documentation, but you can deduct many of the costs of running your own business, including:

  • Raw materials and supplies needed to create items for sale
  • Car and truck expenses for vehicles used for business purposes
  • Wage or salary payments to employees
  • Rent or other bills related to your business premises
  • Insurance premiums
  • Advertising costs
  • Legal and professional fees
  • Home office expenses

Overlooked Tax Deductions

  • First Job Moving Expenses—If you have to move more than 50 miles to take your first job, you can deduct $0.23 for each mile you drive to get yourself and your household belongings to your new location. You can even take this deduction if you take the standard deduction instead of itemizing.
  • Job Hunting Expenses—While the cost of looking for your first job doesn’t qualify, any expenses you incur on the job market later in life, including employment agency fees, transportation costs, and necessary printing expenses for resumes or business cards, can earn you a tax deduction.
  • Military Reserves Travel Costs—If you’re enlisted in the military reserves and you have to travel more than 100 miles and stay overnight to attend training or drills, you can deduct certain costs of transportation, lodging, and meals.
  • Estate Tax for Inherited Assets—If you inherit assets, such as retirement accounts for which the deceased taxpayer’s estate paid taxes, you can deduct the amount of estate tax paid for the inherited asset.
  • Mom and Dad, Thanks for College—If you stay as a dependent, your parents can deduct your college tuition. You get an education, they get deductions. (Just don’t tell them you’re a philosophy major. Deductions don’t cover 20 years of unemployment!)

    Fun Facts:

    • In South Carolina, taxpayers who donate a dead deer to the poor can take a $50 tax deduction.
    • In Hawaii, you can get up to a $3,000 tax deduction if you grow state-approved trees.
    • A hairstylist once managed to deduct the entire cost of her wardrobe. Since she wore it while working, she counted it as a business expense.

There are about 3,700,000 words in the federal tax code …compare this to the roughly 170,000 words in the Oxford English dictionary or roughly 1,000,000 in the entire Harry Potter Books

References

  1. Bella, Laura La. How Taxation Works. New York: Rosen Pub., 2011. Print.
  2. “Credits & Deductions for Individuals.” Credits & Deductions for Individuals. IRS, 2 Jan. 2015. Web. 06 Feb. 2015.
  3. “8 of the Craziest Illegal Tax Deductions Ever Claimed.” – TurboTax Tax Tips & Videos. TurboTax, 2015. Web. 12 Feb. 2015.
  4. “Forms and Pubs.” Internal Revenue Service. Internal Revenue Service, n.d. Web. 11 Feb. 2015.
  5. O’ Bannon, Mark. “Word Count and Story Length | Better Storytelling.” Word Count and Story Length. Better Story Telling, 2010. Web. 06 Feb. 2015.
  6. “Rules for Claiming a Dependent on Your Tax Return.” TurboTax Tax Tips & Videos. TurboTax, 1 Jan. 2015. Web. 09 Feb. 2015.
  7. Weisenthal, Joe. “Tax Facts That Will Make Your Head Explode.” Business Insider. Business Insider, Inc, 13 Apr. 2010. Web. 06 Feb. 2015.
  8. http://www.efile.com/legitimate-tax-breaks-and-unusual-extraordinary-qualified-tax-deductions-and-tax-exemptions/
  9. http://blog.turbotax.intuit.com/deductions-and-credits/what-are-tax-deductions-4318/
  10. http://www.kiplinger.com/article/taxes/T054-C000-S001-the-most-overlooked-tax-deductions.html