Writing off an expense as a tax deduction is often framed as an easy way to put money back in your pocket — but it is a little more complicated than that. A tax deduction simply allows you to lower your taxable income, and a lower taxable income can result in paying less in taxes. Note that this is distinct from a tax credit, which can actually “reduce the amount of taxes you owe, dollar for dollar,” says SmartAsset. To make matters even more complicated, there are also standardized vs. itemized deductions.
Before your head starts spinning and you throw up your hands in frustration, read on for a simple rundown of how tax deductions really work, plus how they differ from tax credits and how you can claim them. It’s worth the effort, as “when it comes to filing your taxes, understanding deductions is vital to maximizing your potential refund or minimizing what you owe,” said H&R Block.
What is a tax deduction?
“A tax deduction is an amount that you can deduct from your taxable income to lower the amount of taxes that you owe,” says Investopedia. In other words, says Fidelity, “if you claim a $1,000 deduction, it means you don’t pay tax on that $1,000,” and “if you’re in the 22% federal tax bracket, you just saved $220.”
That said, just how much of an effect a tax deduction ultimately has on your tax bill depends on what tax bracket you are in. “If you’re in the 10% tax bracket, for example, a $1,000 deduction would only reduce your taxable income by $100 (0.10 x $1,000 = $100),” says SmartAsset.
How do tax deductions differ from tax credits?
As previously noted, tax deductions are distinct from tax credits — though both have the potential to reduce your final tax bill. While tax reductions lower your total taxable income, which is “the amount you use to calculate your tax bill,” tax credits “are subtracted directly from the taxes you owe,” says Investopedia. Here’s an example of how this would work, per SmartAsset: “If you qualify for a $1,500 tax credit and you owe $3,000 in taxes, the credit would reduce your tax liability by $1,500.”
Generally speaking, “a tax credit can have a larger impact because it reduces your taxes owed instead of reducing the income you’ll get taxed on,” says Nerdwallet. One caveat here, says SmartAsset, is that some tax credits are non-refundable, which means “that if the credit reduces your tax liability to a negative number, what’s left over cannot be used to increase the size of your tax refund.”
How can you claim tax deductions?
Does it sound enticing to knock some money off your taxable income? When it comes to claiming tax deductions, there are two ways you can do it: with a standard deduction or an itemized deduction. “The difference between the standard deduction vs. itemized deduction comes down to simple math,” says H&R Block, as “the standard deduction lowers your income by one fixed amount,” while “itemized deductions are made up of a list of eligible expenses.”
As you may have anticipated based on those two descriptions, standard deductions are easier to claim — “you don’t have to do anything to qualify for the standard deduction or provide any documentation,” says Nerdwallet. Instead, you just claim your deduction on Form 1040.
For itemized deductions, you’ll need to fill out Form 1040 as well as Schedule A. This process entails “adding all applicable deductions and subtracting the sum from your taxable income,” says H&R Block. Common itemized deductions might include charitable deductions, deductions for state and local taxes, home mortgage interest, student tuition and fees, contributions to health savings accounts or traditional IRAs, and unreimbursed dental and medical expenses.
You can only claim one, not both — so when should you choose the more involved itemized deduction over the standard deduction? Put simply, if it does more to lower your taxable income. However, says Investopedia, “contrary to what many taxpayers may think, they might benefit most from the standard deduction because the TCJA [Tax Cuts and Jobs Act] nearly doubled the standard deduction amount and eliminated (or capped) many itemized deductions.”