What is tax deduction and how does it work?
Unclear on how tax deduction works? Learn what income deductions are and why they're important. Read on to learn more!
by Sabrina Paes
The essential guide to tax deductions and how they work
A tax deduction is a complicated and often confusing part of the economic process, but understanding it can be incredibly beneficial. After all, how does tax deduction work?
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Knowing the ins and outs of tax deductions can help you save money on your taxes. Moreover, ultimately increase your overall income. Read more about what exactly tax deduction is and how it works!
What is tax deduction, and how it works?
A tax deduction is an amazing tool for reducing how much tax you owe, but how does it work?
Tax deductions lower your taxable income, and the amount of tax you owe is calculated based on your taxable income.
This means that a deduction’s effect depends on your tax rate. When filing taxes, you must decide whether to take or itemize the standard deduction.
There’s no mixing and matching here, so choose carefully! Whichever route you choose, it can effectively reduce how much money goes to Uncle Sam year after year.
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Difference between tax deduction and tax credit
Understanding how a tax deduction works can be confusing. Knowing the difference between a tax deduction and a tax credit.
A tax credit reduces your dollar-for-dollar tax bill, while a tax deduction lowers your taxable income.
Furthermore, tax credits generally fall into two categories: refundable and nonrefundable.
Refundable means you may be eligible for an additional check if you have an excess after using the credit to cover all your taxes owed.
On the other hand, if it’s nonrefundable, though, any unused balance won’t be refunded to you.
What are the types of expenses that can be deducted?
Understanding how tax deduction works is important to how individual taxpayers can save money. Tax deductions reduce the total amount of income you must pay taxes on.
In this sense, you can deduce charitable donations, medical expenses, state and local taxes, student loan interest, retirement and investing contributions, and more.
Knowing how to take advantage of these deductions equips individuals to maximize their savings as much as possible. Learn more about the categories.
Interest associated with student loans
Tax deductions can be a great way to lighten the burden of student loan payments on your monthly finances.
Student loan interest is a deduction that you can claim on your taxes up to $2,500.
This type of tax deduction does not require itemization as it is an adjustment to income.
As your income increases, however, the amount for this tax deduction decreases gradually.
So how does this work? It’s simple – paying off student loans with after-tax money decreases how much money you make from which the government takes taxes.
Earned Income Tax Credit (EITC)
Knowing how to take advantage of tax deductions can make expenses easier.
For example, the IRS lets you deduct medical expenses over 7.5% of your taxable income on items.
These items include appointments with doctors or dentists, prescription drugs, eyeglasses or contacts, and health insurance premiums (paid for with after-tax dollars).
It’s simple math; if your adjusted gross income is $50,000, then 7.5% of that is $3,750.
So if you have $5,000 in medical expenses not covered by your health insurance, you could subtract the $3,750 from that amount.
Donations to charities
You can reduce how much of your taxable income you owe through deductions for charitable gifts.
If you itemize, money donated to churches, educational institutions, and charities is generally deductible up to 60% of your taxable income.
For those who do not itemize, the spending package passed in 2019 allows for an above-the-line deduction of up to $300 for individuals and $600 for married filing jointly.
So don’t forget to take advantage of these deductions when filing your taxes!
Taxes associated with local and state services
One tax deduction that people often forget about is the state and local tax deduction.
The IRS allows taxpayers to deduct their state and local sales or income tax, plus some foreign taxes.
To calculate your potential deduction, you can use the IRS tax calculator online to decide which tax deduction will give you the largest relief on your tax bill.
Additionally, if you’re a homeowner, you can deduct property taxes associated with your home from your total tax liability.
However, there is a limit to the amount of income, sales, and property taxes you can deduct for 2018; for all three combined, it cannot exceed $10,000.
Standard vs. itemized deductions
Generally, taxpayers can claim either standard or itemized deductions on their income tax returns.
Most taxpayers’ standard deductions are the same based on filing status (single, married, etc.).
Itemized deductions are more complex and can include eligible expenses such as medical bills, state taxes paid, and charitable donations.
Depending on how much you spend in these areas each year, one deduction might work better than the other in saving you money every April.
However, research and understand how both types of deductions work before choosing how to proceed.
How to calculate your tax deduction?
Calculating tax deductions is an important financial step that requires careful consideration.
Taking the standard deduction or itemizing each can save you money, and figuring out which option is best for you requires several documents, records, and tax return forms.
To ensure you benefit from the tax deduction, it is wise to use specialized tax software or enlist the help of a tax professional.
This way, all your expenses will be considered, so you don’t miss out on any tax savings.
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