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How does tax deduction work?

How does tax deduction work?
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Most of us dread filing our tax return each year. But completing it on time is crucial if you want to ensure any tax refunds or plus-up stimulus payments you’re due get to you as soon as possible and that you avoid failure-to-file penalties.  

Keeping your tax bill as low as possible will no doubt be one of your key goals when filing, and an effective (and completely legal) way to do this is to claim tax deductions. Providing you know what they are and how they work, they could save you a considerable sum of money. 

Using the best tax software can help ensure you make the most of any tax credits and tax deductions you’re entitled to. And by using it alongside the best personal finance software, the process of filing your tax return should also be more palatable.  Here’s how…

What is a tax deduction?

A tax deduction lowers a person’s or organization’s taxable income and this in turn reduces their tax liability. Tax deductions are usually expenses that are incurred throughout the year which can then be subtracted from your income, reducing your taxable income and thus your tax bill. 

There are two main ways to claim tax deductions. You can choose to either take the standard deduction or take itemized deductions. It is not possible to do both.

How does tax deduction work?

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Standard deduction

The standard deduction is a specified amount that taxpayers can subtract from their income if they are not itemizing deductions. This fixed amount changes each tax year and will depend on your filing status, your age, your spouse’s age and whether you or your spouse are blind. 

In 2021, the standard deduction is:

  • $12,550 for single filers and married couples filing separately
  • $25,100 for joint filers
  • $18,800 for those who are the head of their household

There’s an extra deduction for those who are at least partially blind or at least 65 years old. If this applies to you and you’re also using the single or head of household filing status, the additional standard deduction is $1,700. For those who are married and 65 years or over or blind, the standard deduction is $1,350 higher. The additional deduction amount is doubled for anyone who is both 65 or over and blind. 

How does tax deduction work?

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Itemized deductions

Itemized deductions allow you to reduce your tax bill by subtracting qualified expenses from your adjusted gross income. In some instances, these will exceed the standard deduction which means you could see a more sizeable reduction in your tax bill. 

You can typically claim itemized deductions in the following categories: 

  • Medical and dental expenses: You can deduct medical expenses if they exceed 7.5% of your adjusted gross income for the tax year. This means if you earned $60,000, you wouldn’t be able to deduct the first $4,500.
  • Mortgage interest: If you bought a home after December 15, 2017, you can deduct the mortgage interest paid over the past year on the first $750,000 of the mortgage. Married couples filing separately can deduct interest on up to $375,000 each. For mortgages originating before December 16, 2017, the former limit of $1 million applies (or $500,000 for married couples filing separately).
  • Charitable donations: Most donations you make can be deducted, provided they are to a 501 (c) (3) organization.
  • Student loan interest: If you paid interest on your student loans during the year, you’ll be able to deduct up to $2,500 from your taxable income.
  • Gambling loss: The amount of gambling losses you can deduct must not be more than the amount of gambling income you reported on your return. You’ll need to keep a record of all your losses and winnings.
  • State and local taxes (SALT): You’re able to deduct up to $10,000 (or $5,000 if you’re married and filing separately) of your state and local property taxes, as well as your state income or sales taxes.
  • IRA contributions: Contributions to a traditional Individual Retirement Account (IRA) may be deducted but the amount could be reduced if you or your spouse is covered by a retirement plan at work.
  • 401(k) contributions: For 2021, you can contribute up to $19,500 into a 401(k) plan directly from your paycheck without paying tax. This rises to $26,000 if you’re aged 50 or older.
  • Home office: If part of your home is used regularly and exclusively for business purposes, you can deduct a portion of your mortgage or rent, utilities, real estate taxes and repairs maintenance.
  • Health savings account contributions: You can contribute up to $3,600 in an HSA for self-only coverage and up to $7,200 for family coverage. You can put an extra $1,000 in your HSA if you’re 55 or over. Contributions are tax-deductible, and withdrawals are tax-free too, providing you use them for qualified medical expenses.
  • Educator expenses: If you are an eligible educator you can deduct up to $250 of unreimbursed trade or business expenses.

You’ll need to report all itemized deductions on Schedule A of the 1040 tax form. A paper trail will be required to support deductions for certain expenses such as charitable donations and medical expenses.

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Which is best for you?

Whether you should choose the standard deduction or itemized deductions will largely depend on your individual circumstances. You’ll need to consider whether the amount you spend on deductions such as mortgage interest and medical expenses exceeds the standard deduction. 

If it does, it will make sense to itemize and claim as you’ll be able to reduce your taxable income by a larger amount. But keep in mind that the process of itemizing is more time-consuming, and you’ll need to prove that you’re entitled to the deductions. 

If, on the other hand, your itemized deductions are less than the standard deduction, you’ll save both money and time by taking the standard deduction. 

What’s the difference between tax deductions and tax credits?

Tax deductions should not be confused with tax credits. A tax credit is an amount of money that you can subtract directly from taxes owed to the government. So, whereas a tax deduction reduces the amount of taxable income, a tax credit reduces the amount of tax owed.

Tax credits can include child tax credit, Lifetime Learning Credit, and American Opportunity Tax Credit.