It’s that time of year again. Time to dive into the mystery of tax preparation, and find out how much – or how little – you legally have to pay. Tax deductions have a lot to do with the amount of income tax you actually end up paying at the end of the year, so let’s demystify the tax deduction for you.
What Is A Tax Deduction?
A tax deduction is an amount that you can subtract from your total income from the year. This indirectly reduces the amount of tax that you have to pay.
Your tax is calculated based on your taxable income, which is not the same as the total amount of money you earned during the year.
Tax deductions are subtracted from your total income, leaving you with taxable income.
The amount of tax you pay is then calculated based on your taxable income.
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Tax deductions do not directly reduce the amount of tax you owe, but they do allow you to be taxed on less money.
Common Tax Deductions
While US tax law allows for fewer tax deductions now than before the 2015 Tax Cuts and Jobs Act, there are still common deductions available to many taxpayers.
Most of them are designed to reward certain financial choices, like saving for retirement. Others give tax breaks to groups of people who need it most, like first-time homebuyers and college students.
Retirement account contributions
One of the most common tax deductions is contributions to a retirement account, like a 401(k) or IRA account. If you have retirement contributions deducted from your paycheck every month, this money will not be included in your taxable income.
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If you qualify as low income (less than $21,750 for single filers or $43,500 married joint filers), you may be eligible for an additional “saver’s” tax credit of up to half your retirement account contributions for the year.
Mortgage interest deduction
If you own a home, you can deduct the interest on a mortgage worth up to $750,000. (Sorry, not the mortgage itself – only the interest. Bummer).
You can also deduct up to $5,000 (or $10,000 if filing jointly) of property taxes paid on the house. This tax deduction clearly benefits homeowners over renters, as there is no corresponding tax break for those who rent instead of own.
This tax credit is only available if you choose to itemize your tax deductions.
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Not sure what itemizing means? We’ll get to that in a bit.
Student loan interest deduction
Did you perk up when you heard student loan interest is deductible? Well, good news – some of it can be.
Up to $2,500 of student loan interest that you paid during the year can be deducted from your taxable income.
However, if someone else can claim you on their taxes as a dependent (if you still live with your parents, for example), you will not be able to claim this credit.
The student loan interest deduction is another deduction that can only be claimed if you itemize your tax deductions on your return.
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Standard vs. Itemized
Ok, so what’s the deal with itemized deductions?
Most taxpayers choose to claim the standard deduction, which is a sort of “umbrella” amount that covers any deductible expenses they had for the year.
This makes it easier for people who do not want to save receipts for mortgage interest, student loan interest, state taxes paid, medical expenses, and more.
Instead, they can take the standard deduction, which covers a general amount of tax deductions that an average taxpayer might have in a year.
For 2023, the standard deduction is $12,950 for a single taxpayer and $25,900 for married filing jointly.
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If you really love saving receipts, or you are having a year with unusually high deductible expenses, you can itemize your deductions.
This means saving receipts of all your deductible expenses during the year. You use the exact figure of your expenses to reduce your taxable income.
You are allowed to choose whichever version of deductions gives you the larger tax deduction for the year.
Most taxpayers choose to claim the standard deduction, both for ease of use and because it is rare to have enough expenses to “need” to itemize every year.
Deductions vs. Credits
Are a tax deduction and a tax credit the same thing? No!
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As we explained earlier, a tax deduction reduces your income but does not directly reduce the amount you have to pay.
A tax credit is applied to your return after the amount of tax is calculated, and directly reduces the tax due.
How About My Refund?
So, how can all this affect your tax refund for the year?
If you worked for an employer who withheld taxes from your paycheck all year, you will have paid some money in taxes already.
If your tax deductions reduce your taxable income to the level where you do not need to file, you can still file a return just to get your tax withholdings back.
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If you made enough money that you still need to file a return, but still had more withheld from your paycheck than you owe in taxes, you will still get a refund – and…
The more deductions and credits you have, the bigger that refund can be!
And finally, if you did not have enough withheld from your paycheck, you will still owe taxes after all your deductions and credits are calculated.
This can be a disappointing surprise at tax time, but it doesn’t have to stay that way. A little tax planning can go a long ways toward making next year’s tax season a success.
So now, when you hear your tax preparer (or your uncles) talking about tax deductions, you can know what it means, and how it will affect you.
Now get out there and make your money win!
