Investment Glossary – Income Tax Deduction

No one likes to pay taxes. Actually, that’s probably not a fair statement. In a world of more than seven billion people, there is likely someone, in some remote corner of some city, town, village, or hermitage that enjoys paying taxes for a reason that I have yet to understand. Even people who may be able to rationalize the fact that the taxes they pay help to fund things like schools, police stations, and sewer maintenance still typically don’t like actually writing the check to pay for those things or seeing the money come out of their paycheck. I get it. So we’ll keep this relatively quick so you can understand what an income tax deduction is, and how it may help you pay less taxes.

The primary way in which the United States collects tax revenue is through the personal income tax. The long and short of this is that either you or your employer has to tell the federal government how much money you made last year, and based on that number, you have to pay a certain percentage of your income to the federal government. With the way the system is currently set up in the United States, the income tax is a progressive system, meaning that lower-income workers pay a lower percentage of tax, while higher-income workers typically pay a higher percentage of tax. There are some variations and exceptions (such as capital gains tax and contractor income) based on the tax code, but when we’re talking just in terms of pure income tax rates, this is generally how it works.

One of the ways that you are able to typically reduce your income tax burden is through the use of income tax deductions. A deduction is a provision of the tax code that allows you to reduce how much of your income appears on paper for the purposes of reducing how much tax you pay. So for example, if you earned $50,000 last year, but had a $10,000 income tax deduction, that would imply that when you go to file your taxes, you are effectively going to be taxed on $40,000 of income, since that takes into account the $10,000 deduction you were able to utilize.

With the way the tax code is currently written in the United States, there are two methods in which income tax deductions occur. Individuals and families can choose one of the two methods for employing deductions, but cannot mix between the two methods. The first is what is called the “standard deduction.” For 2020, the standard deduction is $12,400 for individuals who file on their own or as a married person filing separately. For married couples filing jointly, the standard deduction doubles to $24,800, and for heads of household, the standard deduction is $18,650. As the name implies, the standard deduction is the base level of income that an individual can deduct from your earned income in a given year. It applies to everyone, but as mentioned above, this rests on the assumption that someone is not using the second type of deduction method, called “itemizing deductions.”

As opposed to the standard deduction, which is a fixed amount, people who itemize deductions take are able to take advantage of provisions in the tax code where the government allows households to deduct certain kinds of spending from their income. For example, families with significant medical expenses may be able to write off that income if it clears certain thresholds. Other deductions include interest on a mortgage, applied on the first $750,000 of principal, as well as charitable donations and any state and local taxes paid, up to a limit of $10,000 as of 2019. There are several other deductions as well, though the tax code has reduced the number in recent years, largely with the passage of the Tax Cuts and Jobs Act at the end of 2017. But the basic principle is that if someone’s itemized deductions are greater than the standard deduction, then itemizing and taking the total value of their itemized deductions will be more helpful in reducing income taxes.

See? That was pretty simple. Income tax deductions are vehicles spelled out by the federal government in the tax code, by which someone is able to reduce the amount of income that is taxable in a given year. It won’t make you feel better about paying taxes, but understanding how deductions work may allow you to pay less money in taxes in the future.