Nobody wants to pay more taxes than they have to. The two most common ways to reduce what you owe are tax deductions and tax credits. Tax credits reduce your tax bill dollar for dollar, but deductions work differently.
Tax deductions lower your taxable income for the year, which means you pay less in taxes overall.
If you make $50,000 a year and can claim a $2,000 deduction that means your taxable income would be reduced to $48,000. The lower your taxable income, the lower your overall tax owed. Unlike tax credits, a $2,000 tax deduction does not mean you’ll pay $2,000 less at tax time. It just reduces your taxable income, and then your taxes owed are calculated on that lower amount. If you’re taxed at a 20% rate you’d owe $10,000 on $50,000 in taxable income. With the $2,000 deduction your taxable income drops to $48,000 and you owe $9.600 in taxes. That $2,000 deduction saved you $400 dollars in this (oversimplified) example.
There are a few ways to claim deductions, but there is one choice everyone has to make every year. Should you claim the “standard deduction” or “itemize” your deductions?
The standard deduction is a fixed amount that the IRS lets you deduct from your income without providing any additional information.
The amount depends on your household/marital status and how you’re filing. But you don’t have to figure out if you qualify for anything, or keep receipts or fill out extra forms.
On the other hand, itemizing deductions requires a bit more work.
Itemizing your deductions means listing each deduction you qualify for out on an additional schedule.
Some of the individual itemized deductions you could list include home mortgage interest, state and local taxes, real estate and property taxes, medical expenses and charitable donations.
So how do you know which option is best for you?
If your total itemized deductions exceed the standard deduction amount, you’ll want to itemize so that you’ll pay less taxes. If your total itemized amount is less than the standard deduction, you’ll use the standard deduction.
Most people (an estimated 90% as of 2018) will take the standard deduction. At $12,400 for single filers and $24,800 for married filing jointly it would take quite a few itemized deductions to make itemizing the better option.
While most deductions (other than the standard deduction) are itemized, there are a few available (the student loan interest deduction, contributions to an Individual Retirement Account (IRA) and Health Savings Account (HSA) etc) called “above the line” deductions. These reduce your income before calculating your adjusted gross income.
You can claim these “above the line” deductions, if eligible, whether you are using the standard deduction or itemizing.
Your eligibility requires meeting specific qualifications based on your filing status, current life events and the amount of your income that’s taxable. Be sure to review the criteria on the IRS website to confirm that you qualify.
With so many deductions and credits available it can be helpful to use an online service, tax software program, or a tax professional that will guide you through a list of questions to determine which ones you’re eligible for. If you don’t qualify for any, you can still save money by utilizing any pre-tax accounts (401(k),HSA, FSA) that your employer may offer.
Still have questions? Chat with a BrightDime coach!
**This article was written in March of 2019 (for 2018 tax year) and updated in 2021 to reflect changes made for the 2020 tax year. Make sure you’re considering the most recent tax code before making any changes to your withholdings or tax returns.**