How Tax Deductions Work
"You can deduct that." "You can write that off." "Deductible expenses."
You've probably heard these phrases a hundred times. But what do they mean? What are tax deductions and how do they work? And why are tax deductions so important?
The purpose of tax deductions is to decrease your taxable income, thus decreasing the amount of tax you owe to the federal government. There are hundreds of ways to use deductions to reduce your taxable income, but many people don't know about them or know how to take advantage of them. According to H&R Block, over 4 million people don't claim the tax deductions for which they're eligible [source: H&R Block].
To find out how you can maximize your deductions, it's best to talk to a tax professional, such as a tax preparer or lawyer. It's their job to know about tax deductions, and they can guide you to use deductions efficiently and legally. The earlier in the year you learn about possible deductions, the easier it will be to take advantage of them. This article will teach you the basics so that you'll have a good understanding of the deductions that may apply to you.
A lot of people think that deductions are just for the rich and famous. That's not so. A wealth of tax deductions and credits are available to middle- and lower-income taxpayers. The biggest dividing line in the world of deductions is itemizing. Whether or not you can itemize plays an enormous role in the world of deductions.
In this article, we'll find out what itemizing is, exactly. We'll also discuss how to claim deductions on your federal income tax return, even if you don't itemize. Finally, we'll go through a number of examples of deductions to help you save on your taxes every year.
Useful Tax Information Resources
The U.S. tax code is millions of words long. These articles will help you to cut through the code and get you the tax tips you need.
- 10 Tips for Lower Taxes
- 10 Common Miscellaneous Expense Deductions
- 10 Tips for Filing Military Taxes
- 10 Things You Need to Know About Filing Taxes
- 5 Advantages to Doing Your Own Taxes
presented by TaxACT
Claiming Tax Deductions
If you're unfamiliar with deductions, it helps to understand the different deductions available to you.
Above-the-line deductions are deductions from your gross income. On your tax form, subtract the total above-the-line deductions from the gross income to get the adjusted gross income, or AGI. Everyone who fills out a Form 1040, whether they itemize or not, can claim above-the-line deductions.
A standard deduction is an amount of money the IRS allows you to subtract from your AGI based on your filing status. If you itemize, you don't claim a standard deduction. In 2007, the standard deductions were
- Single, or married filing separately: $5,350
- Married filing jointly, or eligible widow: $10,700
- Head of household: $7,850
Itemized deductions, like the standard deduction, are deductions from your AGI. Think of itemization as a type of receipt. Itemized deductions are simply things you paid for that have an effect on your tax status.
So if your combined itemized deductions are larger than the standard deduction you would normally claim, you should itemize. But if your combined itemized deductions are smaller than the standard deduction you would normally claim, you should just claim the standard deduction. The less you pay in taxes, the happier you'll be.
Here is a list of itemized deductions that can be included in your taxes:
- Job expenses that are not reimbursed by your employer: These include union dues, uniforms you're required to purchase and wear, and business-related vehicle expenses, such as gas and repairs.
- Student loan interest that your parents pay: If your parents don't claim you as a dependent, you can deduct up to $2,500 of the interest your parents paid on a student loan for you.
- Self-owned business: You can deduct office equipment, sales tax on business purchases, health insurance premiums, anything "necessary and ordinary" to perform your business.
- Hybrid car tax credit: The amount of the tax credit depends on the type of hybrid car you purchase or lease, and the credit is only available to the consumer that purchased the car.
- Charity: To see if an organization is eligible for a tax-deductible donation, check out the IRS's Publication 78.
- Casualty and theft: These deductions are applicable for an unexpected loss of property due to theft, fire, natural disaster and other unforseen circumstances.
- Home mortgage interest: In most cases, you'll be able to deduct the entire amount of interest paid on your mortgage for the year.
- State and local income or sales tax paid: Usually, deducting state income tax is better, but some states have sales tax and no income tax. You choose one or the other to write off.
- Personal property tax: These deductions are based on personal property taxed like boats or cars.
- Real estate taxes and points: A point is 1 percent of the value of a home loan. Banks charge you a fee to get a home loan. This fee is expressed in points, which you can write off.
- Gambling losses: If you win a big hand of Texas Hold 'Em, you can deduct any amount that you lost while playing, as long as the amount doesn't exceed how much you won. For example, if you lost $12,000 to card sharps, but you landed $10,000 with your four-ace hand, you could write off $10,000 in losses. Gambling includes lottery tickets.
While this list looks like it contains a lot of deductions, you can't deduct anything you want. Find out what limitations and restrictions exist around tax deductions on the next page. We'll also look at some other deductions that don't have to be itemized for you to get credit for them.
Oops!If you realize too late that you were eligible for certain deductions, you can file IRS Form 1040X to amend your return. But if you have this epiphany more than three years late, you're out of luck.
Examples of Tax Deductions
Unfortunately, you can't just deduct whatever you want at any value. All deductions have restrictions. Here are some examples:
Health care expenses: Your out-of-pocket expenses must exceed 7.5 percent of your AGI before you can start writing them off.
Charity: You can deduct 50 percent or less of your charitable donations to public organizations, such as the American Heart Association, and 30 percent of your donations to private foundations, such as the Bill & Melinda Gates Foundation. If, however, you make contributions that can show capital gain, such as shares of stock, you are limited to 30 percent for public organizations and 20 percent for private organizations.
Earned Income Credit: This credit is limited by income level. If you're married, filing jointly and have two or more dependent children, you can claim this credit only if your income is $38,348 or less.
And some deductions don't require you to itemize them to claim the deduction or credit. These include:
- Moving expenses, if you're moving more than 50 miles to be closer to your job
- Education: In addition to $2,500 of student loan interest, you can write off $4,000 in higher education expenses (tuition and fees). You may also be able to claim the Hope Credit and Lifetime Learning Credit.
- Educators' expenses: For example, a teacher who uses her own money to buy construction paper and markers for her classroom can deduct those expenses (maximum of $250).
- Traditional IRA contributions, to a maximum of $4,000
- Retirement withdrawal penalties: You can arrange a penalty-free withdrawal from a retirement account before the age of 59 ½, but have to pay it back in five years to avoid a higher penalty.
- Credits for self-employed workers: You can deduct half of your self-employment tax, health insurance premiums and contributions to some retirement plans, such as Roth IRAs, SIMPLEs or SEPs. Also, you can claim home-office deductions, such as a percentage of rent, electricity, and phone service, if these costs are business-related.
- Energy credits for buying energy-saving equipment, such as solar panels, or making energy-saving home improvements
- Child tax credit: You may be able to reduce the tax you owe up to $1,000 for each child under the age of 17.
- Child-care credit: This applies to each child under the age of 13 that you paid someone to care for.
To learn more about tax deductions and related topics, follow the links on the next page.
What You Can't DeductHere are some examples of things you can't deduct:
- interest and penalties (such as late-payment penalties) on taxes
- federal income taxes
- gift taxes
- taxes you pay on estates and inheritance