The objective of a federal income tax return is to calculate taxable income. While completing IRS Form 1040 may seem complex at times, the entire process can be broken down into two parts: identifying all sources of taxable income, as well as expenses that can be deducted from income.
What are Tax Deductions?
A deduction is defined as a tax-deductible expense paid by an individual taxpayer. It's subtracted from gross income, thereby lowering taxable income and the filer's overall tax liability. The federal income tax system in the United States is both a tiered and progressive tax. Starting in 2018, there are a total of seven federal income tax brackets ranging from 10 to 37%. As income increases, a taxpayer may find themselves in a progressively higher incremental tax bracket.
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Since tax deductions lower gross income, each dollar deducted results in a percentage savings to the taxpayer. A person in the 10% tax bracket will save 10 cents for every deductible dollar, while someone in the 39.6% bracket will save nearly 40 cents.
Tax Credits versus Tax Deductions
A tax credit is more valuable than a deduction. That's because each tax credit dollar is equivalent to a dollar of additional taxes paid. A $1,000 deduction for someone in the 24% tax bracket reduces their total tax liability by $240, while a tax credit of $1,000 reduces their liability by $1,000.
Finding Tax Deductions
There are three opportunities a taxpayer has to identify income tax deductions. The first is through what are called direct adjustments. These are used to identify a taxpayer's Adjusted Gross Income, or AGI. The second opportunity involves what are called itemized or standard deductions. Finally, taxpayers are allowed to subtract a fixed dollar amount for each exemption, which is the number of dependents claimed on a tax return.
Direct Adjustments
Nearly all adjustments to income involve either completing a schedule or form. Unlike itemized deductions (discussed later), direct adjustments do not have to "beat" a threshold value before they can be subtracted from taxable income.
The categories of direct adjustments include educator expenses, health savings account costs, moving expenses, self-employment tax and health insurance, student loan interest, tuition and fees, and alimony payments. Direct adjustments also include funds placed into a qualified retirement plan such as self-employed SEP and SIMPLE plans as well as contributions to IRAs.
Standard Deductions
The tax code allows filers to take the larger of a standard or an itemized deduction. In 2020, the standard deductions include:
Single or Married Filing Separately: $12,400
Married Filing Jointly or Qualifying Widow(er): $24,800
Head of Household: $18,650
In 2021, the standard deductions include:
Single or Married Filing Separately: $12,550
Married Filing Jointly or Qualifying Widow(er): $25,100
Head of Household: $18,800
Itemized Deductions
Taxpayers determine the total of their itemized deductions by completing Schedule A. The higher of the standard deduction, or the total of Schedule A, is deducted from the filer's adjusted gross income. Itemized deductions fall into six broad categories of expense or cost.
Medical and Dental Expenses
Taxpayers that paid for qualifying medical and dental expenses in excess of 7.5% of their Adjusted Gross Income can deduct the amount in excess of that 7.5%. Examples include prescription medications, diagnostic tests, medical examinations, nursing and hospital care, Medicare supplemental insurance as well as Medicare Part D premiums.
Taxes You've Paid
This category of costs includes general sales tax, state and local income taxes, real estate and personal property taxes (including car registration fees). If a taxpayer owns a home, this will be one of the larger itemized deductions taken on Schedule A.
Interest You've Paid
Homeowners can deduct mortgage interest reported on Form 1098, points paid on a mortgage, in addition to mortgage insurance premiums.
Gifts to Charity
This is one of those deductions that can get individuals into trouble during an audit. The recordkeeping requirements when donating to charity are more stringent than in the past. Gifts by check can be easily substantiated with bank statements. Donations of clothes will require a receipt and an estimated value from the charitable organization.
Casualty and Theft
Deductions include those losses caused by fire, storm, vandalism, theft, automobile and boating accidents, as well as a loss caused by corrosive dry wall. Form 4684 is used to determine the value included on Schedule A, which is the loss in excess of 10% of the filer's AGI.
Job and Miscellaneous Expenses
Includes unreimbursed employee expenses such as safety equipment, uniforms, protective clothing, and union dues. The IRS has an entire publication dedicated to Miscellaneous Expenses: Publication 529. In that publication there are 30 pages of instructions about categories of deductions. A deduction can be taken for job and miscellaneous expenses that are in excess of 2% of the filer's AGI.
Common Tax Deductions
Some of the more common tax deductions for both individuals and small businesses are contained in the following two lists. These lists are meant as a guide; the exact deductions an individual can claim depend on many factors including their filing status, income level, as well as passing certain deductibility thresholds.
Individual Deductions
Mortgage interest paid on a home
Property or real estate taxes
Local and state income taxes
Interest paid on home equity loans
Union and / or professional dues
Capital losses, limited to offsetting of capital gains, associated with items such as the sale of common stock
Certain expenses associated with finding a job
Certain educational expenses, for example costs associated with a current career
Gambling losses, as an offset to gains
Work uniforms or clothing including safety eyewear and shoes
Costs associated with preparing an income tax return including software, professional advice, and filing fees
Some moving expenses
Casualty and theft losses not covered by automobile or homeowners insurance
Business Deductions
Deductions related to employee expenses
Start-up and operating costs or expenses
Business-related meals and travel
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