1040 forms with a note saying “tax time!”

How Does a Tax Deduction Work?

As tax season approaches, both businesses and individuals face numerous challenges with deciphering the complex terminology that comes into play when calculating their obligations. There are so many confusing terms that surface during this time, like property taxes, tax credits, federal income tax, taxable income and tax deductions.

In essence, a tax deduction refers to an eligible expense that an individual or business can subtract from their gross income, thus reducing the amount of income subject to taxation. By understanding and utilizing such deductions, taxpayers can effectively decrease their payable taxes and ultimately maximize their savings during this stress-filled season. It is crucial to consult with qualified tax consulting services to discuss one’s unique financial situation and identify the most suitable deductions according to the federal guidelines to ensure maximum advantages and compliance.

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What does a Tax Deduction Mean?

The simple way to understand it is – a tax deduction is a way to lower your taxable income and ultimately reduce the amount of taxes you owe. If you are looking for tax minimization strategies look for advice from the experts in taxation and income tax at the TPI Group. 

How Does it Work? 

A tax deduction is an expense that you can subtract from your taxable income, reducing the amount of income that is taxed. In other words, if you have a tax deduction of $1,000 and your taxable income is $50,000, your taxable income will be reduced to $49,000, which means you’ll owe less in taxes.

Types of Tax Deductions

There are two types of tax deductions: standard deductions and itemized deductions.

Standard Deductions

The standard deduction is a set amount of money that you can deduct from your taxable income without having to provide any additional information to the IRS. 

Governed by the Internal Revenue Service (IRS), this predetermined sum accounts for various individual factors such as a person’s filing status, age, and additional personal circumstances. Recognizing the importance of economic shifts and adapting to them, the standard deduction undergoes annual adjustments to accommodate inflation, ensuring continued relevance and a just allocation for each fiscal year. 

When faced with the choice between claiming the standard deduction or itemized deductions, taxpayers often seek the option that yields the lowest tax liability, illustrating the strategic significance of this fundamental component in the taxation process.

Itemized Deductions

Diving into the realm of itemized deductions, it is important to acknowledge that these specific expenses provide taxpayers with opportunities to reduce their taxable income. 

At the top of the list, certain state and local taxes play a vital role in this process, albeit with certain limitations. Additionally, mortgage interest serves as another deductible expense, offering some reprieve to homeowners. Philanthropic individuals, too, can reap the benefits by deducting their charitable contributions. Medical expenses, once they exceed a specified percentage of adjusted gross income, qualify for this advantageous tax treatment as well. 

In order to maximize the benefits of itemized deductions, taxpayers must exercise meticulous record-keeping and report their expenses using Schedule A on their tax returns. Ultimately, itemized deductions hold greater potential for those taxpayers whose significant deductible expenses surpass the standard deduction amount, leading to a more favorable outcome when filing.

It’s important to note that you cannot claim both the standard deduction and itemized deductions on your tax return. Therefore, if your total deductions are less than the standard deduction, it makes more sense to take the standard deduction rather than itemizing your deductions.

How to Calculate Your Tax Deduction

To calculate your tax deduction, you’ll need to determine your taxable income and then subtract any deductions you’re eligible for. Here’s how to calculate your tax deduction:

Step 1: Calculate Your Gross Income

Your gross income is the total amount of income you earned during the tax year. This includes wages, salaries, tips, and any other income you received.

Step 2: Determine Your Adjustments To Income

Adjustments to income are expenses that you can deduct from your gross income before calculating your taxable income. Examples of adjustments to income include contributions to a traditional IRA or student loan interest.

Step 3: Subtract Your Adjustments To Income From Your Gross Income

Once you’ve determined your adjustments to income, subtract them from your gross income to arrive at your adjusted gross income (AGI).

Step 4: Determine Your Deductions

Next, determine which deductions you’re eligible for whether it is better to go with the standard deduction or an itemized deduction. 

Step 5: Subtract Your Deductions From Your AGI 

Once you’ve determined your deductions, subtract them from your AGI to arrive at your taxable income.

Step 6: Calculate Your Tax Liability

Finally, use the IRS tax tables to determine your tax liability based on your taxable income and then claim tax deductions.

Person reviewing eligible expenses against income

Examples Of Tax Deductions 

To give you a better idea of how common deductions work in practice, let’s look at a few examples.

Imagine you’re a self-employed freelance writer who earned $50,000 in business income last year. You have a home office deduction. Other common tax deductions are business-related expenses throughout the year, such as a home office, advertising expenses, and computer, and internet service. Also, medical expenses that were paid are deductible expenses. These expenses add up to $10,000. Because they’re necessary for your business, these are tax write-offs.  You can deduct these expenses from your taxable income, which means you’ll only be taxed on $40,000 instead of $50,000.

Now let’s consider a couple who are married, filing jointly. They purchased a home in the past year. They paid $10,000 in mortgage interest and $5,000 in property taxes over the course of the year. Because mortgage interest and property taxes are deductible, the couple can subtract these expenses from their taxable income. Let’s say their combined income was $100,000. After deducting their mortgage interest and property taxes, their taxable income drops to $85,000, which means they’ll owe less in taxes. This is different from a couple that is married filing separately.

Lastly, let’s say you made a $1,000 donation in charitable gifts to a qualified charity last year. Because charitable donations are deductible, you can subtract that $1,000 from your taxable income. If your income was $50,000, you can reduce it to $49,000, which means you’ll owe less in taxes.

Contact TPI Group for All Your Tax Needs

These are just a few examples of the various types of income and tax deductions that are commonly reported on tax returns. It’s important to note that tax laws and regulations can change frequently, so it’s always a good idea to consult with a tax professional and certified public accountants for the most up-to-date information.

If you are looking to maximize your deductions, contact TPI Group for a free tax planning consultation