Understanding Tax Deductions

A tax deduction is the portion of your income that will not be taxed. For example, if you make $50,000 per year and you are entitled to have a tax deduction of $6,000, you only need to pay taxes on the $44,000 instead of the full $50,000 of your income.

If you have a choice between choosing a tax credit or a tax deduction for a particular tax relief, generally, you would choose the tax credit because it offers more benefits. For example, for your college education expenses, you have a choice between using a tuition and fees tax deduction or the American Opportunity, Hope Credit or Lifetime Learning Credit. A tax credit, for the most part, is better than a tax deduction because tax deductions only reduce the amount of your taxable income before arriving at your tax liability. In essence, your liability will only be reduced by the amount of the deduction multiplied by your tax rate. For example, if you have a tax deduction of $3,000 and your tax rate is 20%, your liability will be reduced not by $3,000 but only by $600 ($3,000 x 20%). Whereas, when you say a tax credit of $3,000, this means that your liability will be reduced by the full $3,000.

Categories of Tax Deductions

If you ever looked 1040 Form, you’ll notice that some tax deductions are taken on the first page of the form and some on the second page. In fact, you’ve probably heard about “Above-the-line” and “Below-the-Line” deductions, these are the two main categories of deductions. It is always good to learn these expenses and how they impact your tax liabilities so you can do proper tax planning and reduce your taxes even more.

What is the LINE? The LINE is a reference to the IRS 1040 form that marks the separation between the Adjusted Gross Income (AGI) calculation and itemized/standard deductions sections.

Below are the two categories of tax deductions:

A. “Above-the-line Deductions
Also known as (a.k.a) Adjustments to the Gross Income. In other words, these are deductions before you arrive at your adjusted gross income or (AGI).

Examples:
1. Alimony payment
2. Student Loans Interest
3. IRA contribution
4. Tuition and Fees Deduction

B. “Below-the-line Deductions”
These are deductions that are applied after the AGI amount. These include personal exemptions and the choice between the standard deduction or itemized deductions, whichever is higher (nope you cannot claim both, it is either or!!)

Examples:
1. Personal Exemptions
2. Standard Deduction OR
3. Itemized Deductions

Mortgage interest, points, investment interest, personal property taxes, real estate property taxes, charitable contributions, gambling losses, casualty and theft losses, unreimbursed employee expenses, healthcare expenses, etc

Biggest Mistake Taxpayers Usually Make on Tax Deductions

Have you ever heard someone telling you to go ahead go on a spending spree because you can deduct it anyways? That you’ll get more refunds by incurring more tax deductions? This is the biggest mistake that a lot of people make. I believe you should do stuff such as donate money to charity, spend it on your business, have a child not because it is a tax deduction but because it does benefit you. It is a complete waste of money to throw away a dollar in order to get 20 cents back. That’s what’s happening if you do things just to get the deduction.

Comments

  1. Nice article, understanding the tax deductions and credits available to you can make such a huge difference to your refund to tax bill at the end of the year. I think they should teach tax at school so the general public at least has come clue what is going on!