Deduction

What Is a Deduction?

A deduction is an expense that can be subtracted from a taxpayer's gross income in order to reduce the amount of income that is subject to taxation.

For example, if you earn $50,000 in a year and make a $1,000 donation to charity during that year, you are eligible to claim a deduction for that donation, reducing your taxable income to $49,000.

The Internal Revenue Service (IRS) often refers to a deduction as an allowable deduction.

Understanding Deductions

Taxpayers in the United States have the choice of claiming the standard deduction or itemizing their deductions. Claiming the standard deduction is easier and requires less paperwork and record-keeping. The Internal Revenue Service (IRS) has revamped Form 1040, which most taxpayers now use, and retired the old 1040A and 1040EZ forms.

The estimated percentage of taxpayers who used the standard deduction for the 2020 tax year.

Taxpayers who itemize deductions must use Schedule A Form 1040, an attachment to the standard 1040 form, and are required to fill in a list of their allowable deductions and keep receipts to prove them if they are audited.

This longer form is used by filers who have substantial deductions that add up to more than the standard deduction. Common itemized deductions include interest on a mortgage loan, unreimbursed healthcare costs, state and local taxes, and charitable contributions.

Standard Deduction vs. Itemized Deductions

The vast majority of Americans now take the standard deduction instead of itemizing. Why? Because the standard deduction literally nearly doubled with the Tax Cuts and Jobs Act of 2017, and is revised upwards a bit each year to keep pace with inflation.

If you opt to claim the standard deduction, there are still some itemized deductions you can claim on your income tax return, including eligible student loan interest and tuition and fees.

Deductions vs. Credits

A deduction should not be confused with a tax credit. A tax credit is subtracted from the amount of tax you owe, not from your reported income.

There are both refundable and non-refundable credits. Non-refundable credits cannot trigger a tax refund, but refundable credits can.

For example, imagine that after reporting your income and claiming your deductions you owe $500 in income tax. However, you are eligible for a $600 credit. If the credit is non-refundable, your tax bill is erased but you do not receive any extra money. If the credit is refundable, you receive a $100 tax refund.

Special Considerations

All of the above works for individual taxpayers. Business owners have a much more strenuous chore at tax time. This is because they are taxed on their business profits, not their business proceeds. That means documenting their costs of doing business in order to subtract them from the gross proceeds, revealing the taxable profits.

These allowances are a significant upgrade from levels before the Act was passed. In the 2017 tax year, the standard deduction was $6,350 for single filers and $12,700 for married people filing jointly.

The same is true from the smallest businesses to the largest corporations, although the corporations at least have accounting departments to take care of the paperwork.

Businesses are required to report all of their gross income and then deduct all of their business expenses from it. The difference between the two numbers is the business' net taxable income. Thus, business expenses work in a way that is similar to deductions.