Tax deductions reduce your taxable income and, in the process, reduce your tax liability. Sounds great, right? We all know about the big deductions like the mortgage interest tax deduction. Maybe you’re already in the habit of deducting the basics like charitable donations but you have a nagging feeling that you could be doing better. Maybe you’re wondering whether you should itemize or take the standard deduction. Here’s our break-down of tax deductions.
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How Tax Deductions Work
A tax deduction lets you deduct (subtract) certain expenses from your taxable income. That leaves you with a smaller tax bill. Nice, right? So what’s the difference between a tax deduction and a tax credit? A tax credit directly reduces your tax bill, while a deduction reduces your tax bill indirectly. A $1,000 tax credit means you owe the IRS that much less at tax time. A $1,000 tax deduction reduces your taxable income by that amount. The higher your marginal tax rate the more valuable a tax deduction is. Why? Because 25% of $1,000 is more than 15% of $1,000.
The biggest federal income tax deduction out there is the home mortgage interest tax deduction. For a while, both mortgage interest and credit card interest were tax deductible, but a 1986 tax reform eliminated the deduction for credit card interest. If you’re a renter, the mortgage interest tax deduction might be one factor that you consider when deciding whether to rent or buy.
The Standard Deduction
Before you ask “What can I deduct on my taxes?” you should ask yourself something else. The first relevant question is “Should I itemize my deductions?” The IRS hooks taxpayers up with a Standard Deduction that knocks a little off your taxable income. The size of the Standard Deduction you can claim depends on whether you’re filing as an individual or jointly with your spouse. It also depends on your age, your spouse’s age (if applicable) and your income(s). If you think that your deductions will add up to more than the Standard Deduction, you’ll probably want to itemize your deductions. Tax software can help you figure out if it’s worth your while to itemize your deductions.
Tax Deductible Expenses
The IRS provides a list of tax deductions for individuals and businesses. If you’re taking the DIY approach to filling out your tax returns you can go through the tax deductions list and find the ones that apply to you. If you’re using tax preparation software, that software will walk you through potential deductions to make sure you’re claiming everything you can.
The tax deductions relevant to your situation will depend on what you spent and how you earned your money in the tax year. If you’re a teacher who spent money out of pocket on classroom expenses you can deduct that (up to $250). Work from home? You may be able to deduct some of the expenses involved in setting up and running your home office. Got student loans? You may be able to deduct up to $2,500 of the interest you paid. Did you move to take a new job? You may be able to deduct your moving expenses. The list goes on, of course. The more complicated your financial situation the more likely it is that you’ll need help to minimize your tax bill, particularly if you own your own business. Whether that help comes in the form of an accountant or a tax software program is largely a matter of personal preference and budget.
Tax Deductible Donations
Donating to charity is a way to decrease your tax liability while helping to fund your favorite causes. Donations to qualified charities are tax deductible. For the very wealthy, regular giving – of money, stock, art and other valuables – is a tried and true way of minimizing taxes. To qualify for the deduction the charity must be eligible and you must be able to document that you received no goods or services in exchange for your donation. Providing donors with the proper documentation is standard practice for any charity worth its salt. If you’re concerned that you might not get the paperwork you need, ask questions of the charity before you part with your donation.
A Note to the Wealthy
Remember that wealthy filers are subject to a cap on their deductions. For example, married couples filing jointly whose Adjusted Gross Income (AGI) is $305,050 or more are subject to the limit on deductions. The itemized deductions that are limited include charitable donations, taxes paid, interest paid, job expenses and other miscellaneous deductions. Itemized deductions that are not limited include medical and dental expenses, investment interest expenses, casualty and theft losses and gambling losses. For more on the limit on itemized deductions, see the IRS website.
Tax liability can be tough to predict. That’s one reason to keep a well funded emergency fund that you can draw on in the event that your tax bill is bigger than you anticipated one year. You should go into tax season with a plan, not just for how you will pay your taxes but for what you’ll do with any refund you get. Will you pay off debt or save for retirement? Or maybe invest in your professional development? Having a plan for your tax refund increases the chances that you’ll put it to good use rather than letting that money bleed into your regular spending.
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