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 If you've ever filled out a tax form, you understand that the entire process is all about taxable income and tax deductions. You start out by identifying all of your sources of income such as wages, salaries and tips - all from your W-2 form. Then you figure out how much income you've had from other sources. That could be from rents, interest income, capital gains, pensions, and other similar types of income.
Finding Tax Deductions
The next step is to figure out if you can lower your income through direct adjustments. For the vast majority of citizens this adjustment can be allowable contributions to an IRA. When the adjustments are added to your sources of income, you've got your Adjusted Gross Income or AGI.
Now comes the good part - Tax Deductions! Those wonderful tax deductions! You see, the more deductions we can muster, the lower our tax bill for a given year. Income sources are pretty easy to identify because most people know where their money comes from. But our spending activities that are tax deductible are not always all that obvious.
What are Tax Deductions?
A tax deduction is defined as a tax deductible expense paid by a taxpayer. This deduction is subtracted from gross income, thereby lowering the taxpayer's taxable income and overall tax liability.
The federal income tax system in the United States is both a tiered and progressive tax. There are a total of six federal income tax brackets ranging from 10 - 35%. As income increases, a taxpayer may find themselves in progressively higher tax brackets - and they pay a higher percentage of income tax on each incremental dollar earned.
Since tax deductions lower gross income, each dollar deducted results in a percentage savings to the taxpayer. For example, a person in the 10% tax bracket will save 10 cents for every deductible dollar they can take on their income tax return. While someone in the 35% tax bracket will save 35 cents for every dollar of deduction found.
Tax Credits versus Tax Deductions
A tax credit is much more valuable to taxpayers than a tax deduction. That's because a tax credit is equivalent to a dollar of additional taxes paid. For example a $1,000 tax deduction for someone in the 28% tax bracket reduces their total tax liability by $280, while a tax credit of $1,000 reduces their liability by $1,000.
Standard Deductions
In general, there are two methods for determining tax deductions - Standard Deductions and Itemized Deductions. Knowing this information, you should understand the challenge we all face when doing our taxes - Beat the Standard Deduction with your Itemized Deductions. For 2006, the Standard Deductions are:
- Single or Married Filing Separately - $5,150
- Married Filing Jointly or Qualifying Widow(er) - $10,300
- Head of Household - $7,550
In 2007, the standard deductions for taxpayers increase to:
- Single or Married Filing Separately - $5,350
- Married Filing Jointly or Qualifying Widow(er) - $10,700
- Head of Household - $7,850
Itemized Deductions
So what exactly are these Itemized Deductions? For most of us, there are six broad categories of itemized deductions:
Medical and Dental Expenses
If you've paid for qualifying medical and dental expenses that are in excess of 7.5% of you Adjusted Gross Income, then you can deduct the amount in excess of that 7.5%.
Taxes You've Paid
Here is where you can start to understand just how much money you donate to the government each year to keep things humming. The big ones are state and local income taxes, real estate taxes and personal property taxes.
Interest You've Paid
If you have a mortgage or another qualifying loan, here is where Uncle Sam gives you a break and allows you to deduct the interest portion of your loans.
Gifts to Charity
This is one of those tax deduction sections that can get you into trouble during an audit. Read the directions carefully about what you can deduct and the proof you will need when donating to charity. If you've made gifts by check then you have an automatic paper trail. If you're going to deduct that truck full of clothes you've donated, then make sure you get a receipt and an estimated value from the organization to which you donated the clothing.
Job Expenses
Most of us are reimbursed by our employers for expenses associated with our jobs. But you might pay Union dues that qualify for a deduction.
Miscellaneous Expenses
The IRS has an entire publication dedicated to Miscellaneous Expenses - Publication 529. In this publication you will find 29 pages of instructions about things you might never think of. If you are in the military, an educator, or in the performing arts, it is worth a look.
Common Tax Deductions
Some of the more common tax deductions for both individuals and small businesses are contained in the following two lists. Keep in mind these lists are meant as a guide - the exact deductions an individual can claim depends on many factors including their filing status, income level, as well as passing certain deductibility thresholds.
Common Individual Tax Deductions
Common Business Tax Deductions
- Depreciation of assets
- Deductions related to an employee's expenses
- Start-up and operating costs / expenses
- Business-related meals and travel
Beating the Standard Deduction
Once you've got all your itemized deductions together all you have to do is add them up. The bigger the number, the better and if you can beat the Standard Deduction you're on your way to possibly even getting a tax refund - depending on the taxes you've had deducted from your income along the way. But that is best discussed on another day.
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