Most working Americans jump at the idea of lowering their taxes, and the more deductions you're eligible for, the more you're able to reduce your tax burden. A tax deduction is a reduction of the amount of a person's taxable income. There are many different deductions available to tax filers, and knowing which ones to claim can lower the amount you ultimately pay to the IRS.
How tax deductions work
When you take a tax deduction, what you're essentially doing is exempting a certain portion of your income from taxation. Your resulting tax savings will depend on your effective tax rate. Say you earn $50,000 a year and are eligible for $5,000 in tax deductions. This means you'll only be liable for taxes on $45,000 of income. If your effective tax rate is 25%, then that $5,000 tax deduction will save you $1,250.
Note that there is a slight difference between tax deductions and tax exemptions: Deductions are related to expenses you've paid throughout the tax year, while exemptions are based on your filing status and the number of dependents you claim.
Tax deductions versus tax credits
Though some people use the terms interchangeably, tax deductions and credits are not the same thing. A tax credit is a dollar-for-dollar reduction of your tax liability, whereas a tax deduction lowers the amount of income you'll need to pay taxes on. For example, if you're eligible for a $2,000 tax credit, then you'll automatically save $2,000 on your taxes. If you're eligible for a $2,000 tax deduction, then you'll only save as much as your effective tax rate allows for. So if your effective tax rate is 25%, then a $2,000 deduction will save you $500, which is less than what a credit of the same amount would save you.
Common tax deductions
The good thing about tax deductions is that you're allowed to claim as many as you're eligible for. If you're a homeowner, your mortgage interest and property taxes can serve as tax deductions. Additionally, you can deduct points on a mortgage and PMI premiums.
You can also claim a tax deduction for charitable contributions you make throughout the year. To do so, you'll need to donate goods or money to a registered charity and obtain a receipt confirming your donation.
There are also numerous tax deductions for the self-employed. If you use your car for business purposes, you're allowed to take a mileage deduction. If you conduct business out of your home, you can claim a home office deduction. You're also entitled to deduct direct business expenses, such as computer equipment and office supplies.
Along these lines, if you move for a job, you may be eligible to deduct certain expenses if your new place of employment is far enough away from your old home. And if you're looking for a job, you may be able to deduct certain costs related to your search, such as travel and lodging.
Furthermore, some tax filers are able to deduct their out-of-pocket medical expenses on their taxes. In order for you to claim this deduction, your medical costs must exceed 10% of your adjusted gross income for the year.
Finally, net losses on investments can serve as a tax deduction. When you sell investments at a loss, that loss will first be used to offset gains. Once your losses cancel out your gains, you can deduct up to $3,000 in losses per year to offset your regular income.
Backing up your claims
Any time you take a tax deduction, be sure to have documentation in place to support it. Claiming a large number of tax deductions won't necessarily increase your chances of an audit -- as long as those deductions are legitimate. The key is to be as accurate as possible to avoid problems with the IRS down the line.
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