An Overview of Tax Deductions
It is in your best interest to take advantage of every tax credit and deduction available to you. With tax laws constantly changing and the short-term nature of most tax relief, timing is crucial when it comes to claiming tax breaks on your income tax return.
As you probably know, both tax credits and tax deductions can help reduce the amount of income tax that you have to pay. Each year, millions of taxpayers look for tax breaks that can help them reduce their income taxes. While you should definitely try to claim every tax credit and deduction that you qualify for, don’t forget the fact that tax credits and tax deductions are not the same thing.
There are a few basic differences between tax credits and tax deductions. Tax credits provide a dollar-for dollar reduction of your income tax liability. That means a $1,000 tax credit actually saves you $1,000 in taxes. On the other hand, tax deductions lower your taxable income and they are equal to the percentage of your marginal tax bracket. For example, if you are in the 25% tax bracket, a $1,000 deduction saves you $250 in tax (0.25 x $1,000 = $250).
A tax credit is always worth more than a dollar-equivalent tax deduction, because deductions are calculated using percentages. Referring to the numbers in the examples above, you can see that a $1,000 tax credit offers $750 more in savings than a $1,000 tax deduction.
Types of Tax Deductions
There are 3 types of tax deductions: the standard deduction, itemized deductions, and above-the-line deductions. As you prepare your income tax return, you will need to choose between taking the standard deduction or itemizing your deductions. It is generally recommended that you use whichever type of tax deduction benefits you the most.
The Standard Deduction
The standard deduction is a dollar amount that reduces your taxable income. It is typically adjusted for inflation every year. The amount of your standard tax deduction is based on your filing status and it is subtracted from your AGI (adjusted gross income). The amount of your standard deduction may be reduced if you are claimed as a dependant on another person’s income tax return.
For the year 2013, the standard deduction is as follows:
- $6,100 for individual (“single”) filers
- $12,200 for married couples filing a joint return
- $6,100 for married couples filing separate returns
- $8,950 for “head of household” filers
There is also an additional standard deduction for taxpayers who are over the age of 65 and/or those who are blind. The tax deduction for the blind may be claimed if you (or your spouse) is medically declared to be totally or partially blind as of the last day of the year.
An additional standard deduction for the elderly (over 65) or visually impaired is as follows:
- $1,500 for filers who are “single” and not a surviving spouse
- $1,200 for married filers
Other additions to the standard deduction may also exist for losses from a Federally-declared disaster zone, as well as state/local real estate taxes.
Keep in mind that there are certain groups of taxpayers who do not qualify to claim the standard deduction, including the following (as set forth by the IRS):
- A married individual filing as married filing separately, whose spouse itemizes deductions
- An individual who was a nonresident alien or dual status alien during any part of the year (note that residents of India may be able to claim the standard deduction if they meet certain criteria. Refer to Publication 519, U.S. Tax Guide for Aliens, for more information.)
- An individual who files a return for a period of less than 12 months due to a change in his or her annual accounting period, or
- An estate or trust, common trust fund, or partnership
It is important to note that you cannot take the standard deduction if you are itemizing your deductions. You have to choose one method or the other — ideally the one that will do you the most good. For more information, please see IRS Publication 501 (Exemptions, Standard Deduction, and Filing Information).
If you do not qualify for the standard tax deduction, you may choose to itemize your tax deductions. You can also itemize your deductions if it offers you more benefits than claiming the standard deduction.
Most itemized deductions are based on a minimum (or “floor) amount. This means that you can only deduct amounts that exceed the specified “floor.” There are also income limitations for taxpayers who itemize.
If your AGI (adjusted gross income) exceeds the following amounts, then a portion of itemized deductions is not permitted:
- $250,000 for single taxpayers
- $150,000 for married taxpayers filing separately
- $300,000 for married taxpayers filing jointly
- $275,000 for head of household taxpayers
You should do the math to see whether the standard deduction or itemizing deductions does a better job at lowering your income tax liability. If you decide to itemize your tax deductions, it is important to keep detailed records of those tax deductions ― including documentation for medical expenses, property taxes, charitable donations, interest expenses, and non-business state income taxes.
You may use IRS Tax Form 1040 Schedule A to figure your itemized deductions, and attach it to your IRS Tax Form 1040 (but not Form 1040A or Form 1040EZ).
Finally there are “above-the-line deductions,” which are deducted before your AGI is calculated (instead of after, like the other tax deductions). Due to this feature, many believe that this type of tax deduction is more beneficial to taxpayers. Above-the-line deductions are subtracted from your gross income, and the resulting number is your AGI. Above-the-line tax deductions will apply whether or not you itemize. They are meant to help protect your personal exemptions and itemized deductions from phaseouts.
Some above-the-line deductions include the following:
- Student loan interest
- Business mileage
- Job-related moving expenses
- Contributions to qualified retirement accounts
- Early withdrawal penalties for CDs and savings accounts
- Qualified tuition and fees
There are several different things you can do to help reduce the amount of income tax you owe to the IRS. It is in your best interest to take advantage of every tax deduction and tax credit that’s available to you. Understanding your financial position and personal situation will help you determine which tax breaks you can benefit from.