Overview of Tax Deductions

You don’t have to pay tax on all the income you earn. Part of that income is offset by deductions. If you have $60,000 in total income and $15,000 in deductions, your taxable income is $45,000.

It’s important to distinguish between deductions and credits. As we just saw, a deduction is used to reduce the amount of income that’s taxable. A credit is used to reduce the tax. If you’re in the 25% tax bracket, a $100 deduction will reduce your tax by $25, but a $100 credit will reduce your tax by $100.

Categories of deductions

Deductions fall into several categories:

• Costs associated with an income-producing activity may be allowed as deductions in figuring the amount of income you report from that activity. Examples are depreciation claimed against rental income, or inventory and equipment costs claimed against a retail business.
• Capital losses occur when you sell an investment such as stock or mutual fund shares for less than your basis, which is usually the amount you paid for the investment with certain adjustments. You deduct these losses against capital gains plus up to $3,000 in income from other sources.
• Certain deductions that are allowed even if you choose not to itemize your deductions may be called adjustments or above the line deductions. Examples are deductible IRA contributions and alimony paid. The amount of income left after subtracting these deductions is called adjusted gross income (“AGI”).
• Personal exemptions are deductions you claim for yourself and certain dependents. The 2017 tax law temporarily reduced the size of this deduction to $0, in effect repealing it until 2026. Depending on which way the political winds blow, Congress may make repeal permanent.
• Itemized deductions include medical expenses, state and local taxes, mortgage interest, and charitable contributions, among others. You’re allowed to claim a standard deduction instead of itemized deductions. Most people find that the standard deduction is more favorable until they become homeowners. At that point, the deductions for mortgage interest and property tax sometimes make it advantageous to itemize. The 2017 tax law cut back on itemized deductions and greatly increased the standard deduction (again, until 2026), greatly decreasing the number of taxpayers who will find it advantageous to claim itemized deductions.

Deductions and tax brackets

The value of a deduction depends on your tax bracket: deductions become more valuable as your tax bracket increases. For more information see our explanation of tax brackets.