What Is a Tax Deduction? Comprehensive Guide
A tax deduction is an expense or a financial stipulation that lowers a person’s or business’s taxable income. There are two types of deductions: itemized and standard. Standard deductions are simplified, clearly defined, and can be used regardless of expenses, while itemized deductions require thorough documentation of all the costs and purchases.
Regardless of the category, tax deductions may significantly affect your tax return filing and greatly lower your tax liability.
If you’re self-employed or run a business, your most common tax deductions may include expenses like equipment, advertising, vehicle costs, mileage, or accounting. As an individual, you may receive a tax deduction for medical expenses, student loan interest, children, education, and much more.
It’s worth pointing out that some expenses that used to be deductible may have been cancelled in recent years. A notable example is the suspension of moving expenses as deductions until 2025 following the Tax Cuts and Jobs Act.
While filing a tax return, you should also remember the crucial difference between tax deductions and tax credits. Deductions only reduce taxable income, while credits provide a dollar-for-dollar reduction on the actual tax owed, leading to significant tax-saving opportunities.
How Do Tax Deductions Work?
The goal of tax deductions is to reduce taxable income, which results in lower overall tax liability. With various expenses and even charity donations, you effectively reduce the portion of your income subject to federal income tax. There are quite a few different types of deductions that you may be eligible for, depending on your marital status, number of children, and various expenses throughout the year.
When considering tax deductions, you should always remember the limits and thresholds set for specific types of deductions. For example, to deduct medical expenses, they must exceed 7.5% of your adjusted gross income. Most deductions have similar regulations, so refer to the IRS website if you’re unsure about something.
What Are the Types of Tax Deductions?
When claiming tax deductions on your tax return, you need to choose between these two types: standard deductions or itemized deductions. The first option is much more straightforward and requires less documentation. The second option takes more effort but may lead to higher tax savings if you have many deductible expenses.
Standard Deductions
A standard tax deduction is a fixed amount the IRS sets that varies depending on your filing status. As an individual taxpayer, you can simply use the standard deduction, which has almost doubled under the Tax Cuts and Jobs Act (TCJA) in 2018. The change applied to:
- standard deduction for single filers: $12,000 (raised from $6,500)
- standard deduction for married couples or joint filers: $24,000 (raised from $13,000)
- standard deduction for heads of household $18,000 (raised from $9,550)
For 2024, standard deduction numbers were set even higher:
- $14,600 if you’re single or married but filing separately
- $29,200 if you’re married and filing together (also may apply if you’re a widow\er)
- $21,900 if you’re a head of household (which means having a child or a qualifying relative under your care)
Due to those changes, standard deductions may be substantial for most taxpayers and usually will be a better choice. However, if your deductible expenses exceed the standard deduction, you may save more money by itemizing your deductions. That requires thorough recordkeeping of all the relevant expenses over the year and a good understanding of the IRS regulations regarding what and how expenses can be deducted.
Opting to take the standard deduction means you don’t have to keep detailed records of each qualifying expense throughout the tax year. It makes the tax process very easy, particularly for those who have fewer deductible expenses or prefer less detailed financial record-keeping.
Itemized Deductions
Itemized deductions allow you to deduct eligible expenses from your taxable income. When your total expenses exceed the standard deduction this may result in more savings. You can include expenses such as mortgage interest, medical expenses, and charity donations.
To calculate itemized deductions, you need to add up all your eligible deductible expenses and subtract this total from your adjusted gross income (AGI). The appropriate form to do that is the Schedule A (Form 1040).
This process is more time-consuming and requires diligent record-keeping. However, if you’ve had significant deductible expenses in a tax year, itemizing could potentially save you more money than opting for the standard deduction.
What Are Common Tax Deductions?
The list of possible tax deductions includes expenses such as:
- Student loan interest
- Mortgage interest
- Retirement savings contributions
- State and local taxes
- Mileage (using the IRS standard mileage rates)
- Health savings account contributions
- Medical and dental expenses
- Self-employment expenses
- Charitable contributions
- Investment losses
- Gambling losses
Each of these deductions has specific rules and limits. For instance:
- you can deduct only up to $2,500 of student loan interest annually
- you can deduct mortgage interest only on your primary and secondary residence (within specified limits)
- you can deduct medical expenses only if they exceed 7.5% of your adjusted gross income
Due to these limits and thresholds, we highly recommend checking the newest regulations on the IRS website. Any errors or inconsistencies in your tax return may lead to an audit, during which the IRS will require proof of all the expenses.
What Tax Deductions Are No Longer Available?
Being up to date with the latest changes and tax regulations is crucial for another reason. They change quite frequently. Over the years, many deductible expenses have been suspended and even cancelled.
Here are some of the most notable examples of tax deductions that aren’t available anymore:
- Home equity loan interest (unless you spent the money to improve the home)
- Mortgage interest on more than $750,000 of secured mortgage debt
- Unreimbursed work expenses
- State and local taxes above $5,000 (or $10,000 for a couple)
- Dues for professional societies
- Moving expenses (except for military personnel)
- Casualty and theft losses (except in federally declared disaster areas)
- Tax preparation fees
- Alimony payments
- "Miscellaneous" itemized deductions
Which Tax Deductions Apply to Self-Employed Individuals?
If you’re self-employed, there’s a specific set of tax deductions that you can use to lower your taxable income. Here are the most common ones:
- Necessary business expenses
- Health insurance premiums, including age-based premiums for long-term care coverage
- Business-related travel
- Vehicle expenses
- Business mileage
- Home office expenses if a portion of your home is used exclusively and regularly for business
- Marketing and advertising
- Phone and internet services
- Retirement plan contributions
- Self-employment tax using Schedule SE
- Contributions to specific retirement accounts like IRAs, depending on their income level.
Which Tax Deductions Apply to Small Business
The possible tax deductions for small businesses are quite similar. Like self-employed individuals, small businesses can deduct all business-related expenses, utilities, health insurance, startup and organizational costs, vehicle costs, etc.
However, there are a few more possible options, which rarely apply to self-employed.
- Expenses related to hiring employees
- Employee benefits
- Section 179 deduction
- Inventory costs
How to Claim Tax Deductions?
The process of claiming tax deductions boils down to three steps:
- Gathering all necessary documents and information detailing your deductible expenses.
- Deciding whether to opt for the standard deduction or itemized deductions.
- Accurately reporting the chosen deductions on your tax return.
The decision between taking the standard deduction or itemizing deductions is key. The first option guarantees an easy process, while the second can provide much better savings.
Once you’ve chosen your method and compiled all necessary documentation (receipts, invoices), you need to fill out all the relevant forms on your tax return.
For example, as a self-employed person, you may need to fill out:
- Form 1040: Main individual income tax return form used by all taxpayers.
- Schedule C (Form 1040): Here you report income or loss from a business you operated or a profession you practiced. It includes details of your business income, expenses, and it calculates your net profit or loss, which is then transferred to your Form 1040.
- Schedule SE (Form 1040): On this form, you calculate the self-employment tax owed on your net earnings from self-employment.
How Do Tax Deductions Affect Tax Returns?
Tax deductions are essential for your yearly tax return. They lower your taxable income, reducing your tax liability. In addition to tax credits, deductions can play a massive role in your overall budget.
With some rigorous recordkeeping and a decent knowledge of the possible tax deductions, you can finish your tax year with a smile on your face.
Tax Deductions vs. Tax Credits
Tax deductions and tax credits play different roles. Tax deductions lower your taxable income, whereas tax credits directly reduce your tax liability on a dollar-for-dollar basis. This means tax credits can have a more substantial impact on reducing your tax bill compared to tax deductions.
Some of the most commonly used tax credits include:
- Child tax credit
- Family and dependent credit
- Education credit
- Adoption credit
- American opportunity credit
- Lifetime learning credit
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