What Is A Tax Deduction?
Tax deductions work to ultimately lower your tax bill, but how many deductions can you take, and what's the difference between a tax deduction and a tax credit?
Tax deductions are a great way to lower the amount of taxes you owe the IRS each tax season. But how exactly do tax deductions work?
By knowing the basics of what tax deductions are and how tax deductions operate, you’ll be able to understand how to lower your overall taxable income and take the deductions you’re eligible for with confidence this tax season.
Table of Contents
What Is A Tax Deduction?
A tax deduction is an expense that reduces your overall taxable income.
Each year, the IRS requires taxpayers to pay a percentage of the money they earn — this is taxable income. The percentage paid depends on how much income you earn. The more you earn, the higher your percentage rate will be.
Tax deductions work to reduce your total taxable income, which ultimately saves you money on your tax bill. (Whereas a tax credit lowers your tax bill directly — but we’ll get to more on that later.)
For example, say John earned $50,000 in 2023. According to the 2023 tax brackets (pictured below), John would have to pay 22% in taxes. But, lucky for John, he had $10,000 worth of eligible tax deductions, which would lower his taxable income to $40,000. This means he’ll now be taxed at 12%, saving him a significant amount of money on his tax return.
Even if your total tax deductions aren’t enough to move you down an entire tax bracket, by taking eligible tax deductions, you will still pay less than if you were taxed on a higher total income.
Tax Deduction Rates For The 2023 Tax Year
|Income Range For Single Filers
|Income Range For Joint Filers
|Less than $11,000
|Less than $22,000
|$11,000 – $44,725
How Tax Deductions Work
Tax deductions work to lower your overall taxable income. But how exactly does that work? Taxpayers can claim eligible deductions to lower taxable income, which works to reduce the amount of money that you can be taxed on so that you end up paying less in taxes.
The way to calculate tax deductions is to:
- Take your gross pay amount and subtract any pre-tax deductions
- Subtract payroll taxes
- Subtract any post-tax deduction to get your adjusted gross income amount
- Decide between the standard tax deduction or the itemized tax deduction
- Subtract your total deduction (either the standard deduction or the sum of all itemized deductions) from your adjusted gross income to get your total taxable income
What Expenses Can Be Deducted?
The exact expenses that you can deduct depend on your filing status and vary based on whether you are filing a personal tax deduction or a business tax deduction.
Individual tax deductions usually revolve around charitable donations, clean energy purchases, medical expenses, and certain tax payments or interest payments, while business deductions are more expansive and cover a large number of common business purchases.
Examples Of Individual Tax Deductions
While the gambit of individual tax deductions is huge, here are a couple of common ones:
- Charitable donations
- Interest payments
- Medical expenses
- Health insurance
- Personal property tax
Examples Of Business Tax Deductions
There’s a long list of business tax deductions. Some common business tax deductions include:
- Business vehicles & mileage
- Office supplies & furniture
- Home offices
- Real estate cost segregation
If you run a business, check out our complete list of small business tax deductions to make sure you’re taking all of the tax breaks you qualify for.
Pre-Tax Deductions VS Post-Tax Deductions
Exactly how a tax deduction affects your tax return depends on whether the deduction is a pre- or post- tax deduction. Pre-tax deductions and post-tax deductions apply to when the tax deduction is taken and can play a significant part in how your overall taxable income is lowered.
What Is A Pre-Tax Deduction?
A pre-tax deduction is taken out of a taxpayer’s gross pay before other taxes (like FICA and Social Security) are taken out of their paycheck. Typical pre-tax deductions include 401(k), HSA, FSA, or life insurance contributions, among others.
Because these contributions are deducted straight from your gross pay before taxes, you end up paying less in taxes overall, effectively reducing your taxable income.
What Is A Post-Tax Deduction?
A post-tax deduction means that the deduction is taken out of the taxpayer’s net pay after taxes (like FICA and Social Security) have already been taken out of their paycheck. Contributions to Roth 401ks, disability insurance, union dues, some healthcare and FSA accounts, and garnishments all fall into this category.
One way to think about it is that pre-tax deductions reduce gross pay and post-tax deductions reduce net pay.
Once pre-tax and post-tax deductions are calculated, the remainder is called your Adjusted Gross Income or your total taxable income.
If the difference between pre-tax deductions and post-tax deductions is still fuzzy, check out our complete guide to understanding payroll taxes for more information.
What Are Above-The-Line Tax Deductions?
Above-the-line tax deductions refer to deductions that make up your Adjusted Gross Income. This would include both pre-tax and post-tax deductions.
What Are Below-The-Line Tax Deductions?
Below-the-line tax deductions are standard deductions that are itemized to reduce your overall taxable income.
Above-the-line tax deductions are still taken out of your check, while below-the-line tax deductions are for expenses that you purchase with the money that you earn.
Standard Tax Deductions VS Itemized Tax Deductions
During tax season, taxpayers can choose to take either the standardized or itemized tax deduction. The best deduction method is going to be the one that gives you the biggest tax break. Here’s how both methods work and how to choose between the standard and itemized deduction.
What Is A Standard Tax Deduction?
The IRS allows a standard tax deduction amount for taxpayers. The standard deduction is a set amount that reduces your taxable income. The amount varies based on your filing status and is subject to change from year to year.
Most everyone is eligible to take the standard deduction (exceptions include if you are filing as a trust, estate, or partnership, or if you are married filing separately and your spouse takes the itemized deduction route).
The benefit of the standard deduction is that it’s one flat deduction amount, which makes calculating the deduction easy. For many taxpayers, the standard deduction is also going to result in a bigger tax break. However, certain taxpayers benefit more from the itemized deduction route.
This year’s standard deduction is:
|2023 Standard Deduction Amount
|Married Filing Separately
|Married Filing Jointly
|Head of Household
What Is An Itemized Tax Deduction?
An itemized tax deduction is a deduction method where each expense is “itemized” or recorded and tallied to reduce your taxable income.
For individuals, itemized tax deductions can include charitable donations, interest, property tax, medical expenses, and more. For businesses, itemized tax deductions can include office supplies, software, employee wages and benefits, utilities, and more.
Recording and calculating itemized tax deductions is a lot more intensive than just claiming the standard tax deduction. However, if you have enough qualifying tax deductions, you could potentially save more with itemized tax deductions. This is especially true of taxpayers who make regular, generous charitable donations or who have incurred a large amount of medical expenses.
Even if you plan on taking the standard deduction, it’s always good to check the total of your qualifying itemized deductions to double-check that you are getting the largest tax break possible. If you use an accountant or certified tax preparer, be sure to provide them a list of all itemized deduction expenses so that they can calculate which deduction method will lower your taxable income the most.
Tax Deductions VS Tax Credits
Both tax deductions and tax credits lower the amount of taxes you owe; however, the way tax credits and tax deductions work is fundamentally different. Tax deductions lower your taxable income so that your tax bill is smaller, while tax credits reduce your tax bill itself so that you owe less or may even receive a tax refund from the IRS.
The good news is that you can use tax deductions and tax credits together as long as you meet the eligibility requirements for each tax deduction or credit.
Learn more about how tax credits work, so that you have the best shot at getting a tax refund check from the IRS this year.
If you run a business, look into the employee retention credit tax credit to see if you qualify for this substantial tax break.
How To Claim Tax Deductions
The exact process for claiming your tax deductions is going to vary significantly depending on your filing status. If you run a business, it will also depend on your business structure. Some business types are considered “pass-through” in that the business taxes you pay pass through your personal income. Other business structures, like LLCs, are their own entities and have a different process entirely for filing taxes.
The best way to claim your taxes is to work with a certified public accountant (CPA) or a certified tax preparer (CTP). They will be able to help you navigate each tax deduction’s eligibility requirements so that you can be sure you’re getting the best tax return possible this tax season.
If you run a small business, don’t forget to check out our free small business tax checklist to get ready for tax season.