Though tax deductions and tax credits are often talked about interchangeably, they are not the same thing, and work in very different ways. Generally speaking, tax deductions lower your taxable income, whereas tax credits directly reduce your tax liability dollar-for-dollar. You can find more information on tax credits here.
Tax deductions lower your taxable income, making a smaller share of your income subject to taxation. For example, if you fall into the 24% tax bracket and receive a $1,000 tax deduction, $1,000 of your income is now immune to taxation. This means that you will effectively save around $240 in taxes that would’ve otherwise had to pay.
It’s useful to think of tax deductions as safeguards that protect a certain portion of your income from being taxed. Therefore, a $1,000 tax deduction doesn’t result in you keeping an extra $1,000; you need to work out the percentages of the tax you will no longer have to pay on this amount, and THAT is the money that you’ll get to keep.
Tax deductions come in 2 main forms: standards deductions and itemized deductions. You can use one system or the other when filing your tax returns, but you cannot use both simultaneously. It is advisable to use itemized tax deductions if their total outweighs the standard deductions you are eligible for (i.e. if you will save more money), though this will depend on your personal circumstances. Below we explain the basic differences between these 2 systems.
Standard Tax Deductions
Standard tax deductions are dollar amounts that reduce your overall taxable income. These are set by the government for the whole country, and are typically adjusted for inflation year by year. Your standard deduction amount eligibility is based on your tax filing status (i.e. single or married filing jointly) and is subtracted from your AGI (adjusted gross income). For 2018, the standard tax deduction amounts are as follows:
-Single: $12,000
-Heads of Households: $18,000
-Married Filing Jointly/Surviving Spouse: $24,000
-Married Filing Separately: $12,000
You can use the IRS Tax Form 1040, IRS Tax Form 1040A, or IRS Tax Form 1040EZ for standard tax deductions.
Itemized Tax Deductions
As aforementioned, itemized tax deductions are best used if their total will outweigh that of the standard government-set tax deductions. You may also not qualify for a standard deduction, meaning that an itemized tax deduction is your best course of action.
It should be noted that some itemized deductions are based on a minimum amount, which is also known as a “floor” amount. This means that you can only deduct amounts exceeding the designated “floor” of your income. Income limits also apply to itemized tax deductions, meaning that if your AGI (adjusted gross income) exceeds a certain level, a certain portion of itemized deductions is not allowed.
Itemizing your tax deductions requires you to keep accurate and detailed receipts and accounts of all necessary transactions. The necessary documentation for medical expenses, charitable donations, mortgage interest, property taxes, and non-business state income taxes should all be kept on file when filing itemized tax deductions, as the IRS will want to ensure your authenticity.
You can use the IRS Tax Form 1040 Schedule A to calculate your itemized deductions, and then attach it to your IRS Tax Form 1040.