What Are Tax Deductions?
Tax deductions are one of the few tax topics that generate some excitement. While nobody likes to pay taxes, everybody loves to use deductions to lower their taxes. To put it plainly, a tax deduction lowers your taxable income, which therefore lowers your tax liability. Some people mistakenly think a tax deduction is a direct reduction of taxes owed. That is actually a tax credit, which does directly reduce the amount of taxes owed instead of simply reducing your taxable income.
Tax deductions come in two major flavors: the standard deduction and itemized deductions. The standard deduction is just that—a standard dollar amount set by the IRS each year. This is the easiest deduction to take because there are no calculations to make, no receipts to gather, and no additional tax forms to prepare. While easy, it may not always be the best choice. That’s where itemized deductions come into play.
Itemized tax deductions require a little more work, but it can also mean a big savings on your total tax bill. For example, in 2009 the standard deduction amount for a married couple filing jointly was $11,400. This is a nice deduction, but if you own a home, make contributions to a retirement account, or made charitable contributions the standard deduction may be less than what you could itemize. In situations like this it obviously makes sense to itemize so that you can maximize your total deduction amount. To itemize your deductions you will need to file 1040 Schedule A.
Itemized deductions fall under these primary categories:
- Medical, dental, prescription drugs, and health care costs
- State and local income taxes or sales taxes
- Property taxes
- Mortgage interest
- Personal property taxes (such as vehicle registration fees)
- Interest paid on certain investments
- Charitable contributions
- Personal losses due to theft or casualty
- Job-related expenses
- Union dues
- Tax preparation fees
- Home office expenses
- Gambling losses
Some Things to Consider
If you do plan on itemizing deductions, there are a few things to consider. First, many deductions are limited to a certain threshold amount. A common example of this is in relation to health care expenses. These expenses are deductible only if they exceed 7.5 percent of your adjusted gross income. So, you may not have enough health expenses to be able to take advantage of the deduction. There are also limitations in effect for higher income earners and if your income is above the threshold for the year they may be reduced.
In addition, itemizing means careful record keeping. You will need to keep all of your receipts and track the expenses you’d like to deduct. In the event of an audit you’d be required to substantiate your deductions, so keeping careful records is crucial.