Deduction: Meaning & Definition

KEY TAKEAWAYS

• Deductions can reduce your income before you calculate the amount of taxes you owe.
• Mandatory deductions are required by law, while optional deductions are voluntary.
• Deductions can save you money by lowering your tax bill.
• There are many different kinds of deductions, ranging from donations to charity to job-related expenses.

What Is A Deduction?

A deduction is an amount you can subtract from your gross income before you calculate the tax you owe when filing taxes. They are expenses that you incur and pay for such as property taxes, business expenses, student loan interest, or health insurance premiums. Deductions reduce the amount of your income that is subject to tax.

This is possible by letting you exclude a specific dollar amount as a reduction in taxable income. When you file your taxes, you deduct certain expenses from your gross earnings to calculate your taxable income. Once calculated, you can use that number to determine how much tax you owe.

What Are The Types Of Deductions?

Work-Related Expenses

These are things you spend money on as a part of your job. They can include tools, training materials, or other supplies required for you to do your job.

Self-Employed Health Insurance

If you are self-employed, you can deduct 100% of your health insurance premiums for yourself, your spouse, and your dependents. 

Home Office Expenses

If you regularly use part of your home as an office, you might be able to deduct some of your utilities, real estate taxes, and repairs.

Student Loan Interest

If you have taken out federal or private student loans to fund your education, you may be able to deduct the interest you pay each year on those loans.

Charitable Contributions

If you donate to a qualified charity, you may be able to deduct the amount of your donation from your taxes.

What is Standard Tax Deduction?

A deduction is a specified dollar amount that is available to all taxpayers and that will reduce your taxable income. Standard deduction is adjusted annually for inflation and is based on your filing status. You can choose to either itemize your deductions or claim the standard deduction, whichever is more beneficial.

The standard deduction amounts for the 2022 tax year are as follows: 

Single: $12,950 

Married Filing Jointly: $25,900

Head of Household: $19,400  

If you do not itemize your deductions, your standard deduction will be the best way to reduce your taxes. 

Note: If you are using the standard deduction, be sure to use the right filing status.

How To Qualify For Deductions

Make Sure The Item Is Deductible

Your expenses must be legitimate and come with a receipt to be deductible. You can visit the IRS website for a full list of deductible items.

Document Your Deductions

If you are claiming a large deduction, such as for work-related travel or education, keep accurate records. Be sure to note the dates, locations, and people you were visiting with, as well as the purpose of the trip.

Be Aware Of The Limits

Some deductions have a maximum amount you can deduct. For example, the amount you can deduct for work-related travel and education expenses is capped at $3,000 per year.

How To File A Deduction

Compare Your Options

If you are taking a large deduction, you have the option to itemize your taxes or claim the standard deduction.

Keep Thorough Records

If you decide to itemize, be sure to keep all receipts related to your deductions. Take photos of receipts if you’re worried about them getting lost.

Track Your Expenses

If the amount you are deducting is small, you may be able to track your expenses using a spreadsheet.

Deductions vs Credits

Deductions reduce the amount of your income that is subject to taxes. Credits can reduce the total amount of taxes you owe or increase your tax refund (refundable credits). Deductions are  based on your specific situation. i.e, student loan interest or unreimbursed job-related expenses. 

Credits are based on a specific criteria, such as being a veteran or having children in your household. You cannot claim a deduction and a credit for the same qualified expense Tax credits are usually considered more beneficial as they directly reduce the amount of tax you owe. The benefit of the deduction depends on your tax bracket.

Example of Deduction

Let’s say you are a single filer with an AGI of $50,000, and you earned your income as a W-2 employee. You have $20,000 in paid student loan interest and $8,000 in unreimbursed job-related travel expenses. For the student loan interest, you may deduct the lesser of $2,500 or the amount actually paid during the year. Since your AGI is less than $70,000, you may claim the full $2,500 deduction (above $70,000 AGI for single head of household filers, the deduction is subject to a phaseout). As of 2018, you can no longer claim any miscellaneous itemized deductions, subject to 2% of AGI limitation, including unreimbursed employee expenses, unless you fall into certain categories of employment.

Look at the following equation to calculate your taxes.

$50,000 AGI – $2,500 student loan interest deduction = $47,500 taxable income. 

Based on your taxable income of $47,500, for 2022, your marginal tax rate is 22%. .

Summary

Deductions are amounts you may deduct for certain expenses from your gross income when you file taxes. While they can reduce your taxable income, you must keep thorough records of your expenses and make sure that you meet the requirements before claiming any deductions.

Written by Sandra Habiger, CPA

Sandra Habiger is a Chartered Professional Accountant with a Bachelor’s Degree in Business Administration from the University of Washington. Sandra’s areas of focus include advising real estate agents, brokers, and investors. She supports small businesses in growing to their first six figures and beyond. Alongside her accounting practice, Sandra is a Money and Life Coach for women in business.

Written by Sandra Habiger, CPA

Sandra Habiger is a Chartered Professional Accountant with a Bachelor’s Degree in Business Administration from the University of Washington. Sandra’s areas of focus include advising real estate agents, brokers, and investors. She supports small businesses in growing to their first six figures and beyond. Alongside her accounting practice, Sandra is a Money and Life Coach for women in business.