Tax Deduction Definition: Standard or Itemized?

What Does Tax Deduction Mean?

A tax deduction is a dollar sum that can be subtracted from your taxable income to reduce your tax liability. On Schedule A of your income tax return, you can opt for the standard deduction, which is a single deduction of a fixed amount, or itemized deductions.

If the sum of your itemized expenses is larger than your filing status’s standard deduction, it makes sense to itemize. Included among the itemized deductions allowed are mortgage interest, charity contributions, unreimbursed medical expenses, and local and state taxes.

Key Takeaways

• Deductions reduce the amount of tax you owe by deducting them from your taxable income.
• On Schedule A of Form 1040 or 1040-SR, you may elect the standard deduction or itemize your deductions.
• The Tax Cuts and Jobs Act (TCJA) increased various tax deductions and nearly quadrupled the basic deduction.
• The Tax Cuts and Jobs Act also removed or restricted several itemized deductions, such as the mortgage interest deduction.
• If you itemize your deductions, be sure to preserve proof of your costs in the form of receipts.

Recognizing Tax Deductions

People have the option of using the standard deduction, which roughly doubled as a result of the Tax Cuts and Jobs Act, or itemizing their deductions. Below is a summary of the standard deduction amounts for tax years 2022 and 2023:

Those who are blind or at least 65 years old can claim an additional standard deduction. The additional amount for 2022 is $1,400 ($1,750 for single filers and heads of households). Individuals over 65 and visually impaired are eligible for double the additional amount ($2,800 or $3,500, depending on filing status). In 2023, the sum increases to $1,500 for single filers and $1,850 for heads of household.

Standard Tax Deductions

Here are many of the most prevalent tax deductions you can claim on your federal income tax return:

• Up to $2,500 of student loan interest is covered.
• Mortgage interest on up to $750,000 of secured home mortgage debt ($1 million if the home was purchased prior to December 16, 2017) is deductible.
• Annual restrictions on contributions to a standard individual retirement account (IRA), 401(k) plan, or another eligible retirement plan
• Up to $10,000 of state and local taxes are deductible.
• Annual maximum contributions to a health savings account
• Expenses for medical and dental care exceeding 7.5% of your adjusted gross income
• Self-employment expenditures, including the deduction for a home office and the deduction for health insurance premiums
• Charitable contributions
• Investment losses
• Losses from gambling

The majority of these deductions must be reported on Schedule A of Form 1040, but there are exceptions.

Form 8949 and Schedule D must be used to report investment losses, whereas Form 5498 must be used to record IRA contributions.

Contributions to an employer-sponsored 401(k) retirement account are automatically deducted from your paycheck, so you do not need the additional form.

Deductions Eliminated In 2018

The Tax Cuts and Jobs Act of 2017 abolished or limited the number of once-common tax deductions (TCJA). The following items are no longer deductible, at least until 2025, when the action is set to expire:

• Mortgage loan interest (unless you spent the money to improve the home)
• Mortgage interest on secured mortgage loan exceeding $750,000
• Unreimbursed work expenditures
• Local and state taxes in excess of $5,000 (or $10,000 for a pair)
• Fees for professional organizations
• Moving expenditures (except for military personnel)
• Accidental and theft-related losses (except in federally declared disaster areas)
• The individual exemption
• Fees for tax preparation
• Alimony payments
• “Unclassified” itemized deductions

Deductions For Self-Employed Taxpayers

Freelancers and gig workers are increasing in number. According to a Pew Research report, there are currently more than 16 million self-employed Americans.

They have preserved a portion of the tax deductions that wage workers lost as a result of the 2017 tax reform law. Certain deductions are complicated because you must assess how much of each item is business-related, and therefore deductible, and how much is personal, and hence nondeductible.

The deductions for half of your Medicare and Social Security taxes, the home office deduction, and the health insurance premiums deduction are among the most crucial for self-employed individuals.

One of the most beneficial deductions for self-employed individuals is the tax deferral on their retirement plan payments. The SEP-IRA, the SIMPLE-IRA, and the solo 401(k) are tax-deferred retirement plans established exclusively for self-employed individuals, sole proprietors, and small business owners.

Small Company Tax Deductions

Companies of all sizes must pay taxes on their earnings, which are calculated by subtracting their entire revenues from their total expenses. This requires noting each and every expense and submitting them to the IRS. Among the most popular deductions for small business owners are:

• Marketing and advertising
• Bad debts
• Books
• Corporate travel
• Charitable contributions
• Continuous training
• Equipment
• Insurance
• Legal and expert expenses
• Licensing and administrative fees
• Loan interest
• Pass-through tax credit
• Fixing and maintaining
• Taxes (local, sales, and property taxes) (local, sales, and property taxes)
• Vehicle expenses
• Initial costs

The requirements for many of these deductions are complex, especially for businesses operating on a tight budget. For example, vehicle expenses and travel expenses must be carefully segregated between company use and personal or family use in order to be deducted.

Tax Deductions vs. Tax Credits

Deductions reduce your total taxable income, which is used to determine your tax liability. In contrast, tax credits are deducted straight from your tax liability. Certain tax credits are even refundable, which means that if the credits reduce your tax liability to less than zero, you will receive a refund.

Even if tax credits are not refundable, they are more beneficial than tax deductions. A tax deduction may lower your taxable income by a few notches on the tax tables, but a tax credit decreases your tax liability dollar-for-dollar.

Illustration Of A Tax Deduction

This is an illustration. Imagine a single taxpayer with a $90,000.00 earning income in 2022. This places the individual in the 24% tax rate. Thus, their tax liability for the 2022 tax year would amount to $15,435.50 ($15,213.50 plus $222) ($15,213.50 plus 24 percent of the excess over $89,075). This individual, like all taxpayers, has the option of itemizing deductions or taking the standard deduction.

If The Taxpayer Itemizes Deductions

The taxpayer has deposited $6,000 to a traditional IRA and paid $10,000 in mortgage interest. Both are deductible costs.

With a total of $16,000 in deductions to record, the taxpayer will owe taxes on $74,000 of earned income ($90,000 – $16,000). Thus, the individual’s annual tax liability is $11,897 ($4,807.50 plus 22% of the excess over $41,775). This is less than the original tax obligation mentioned above of $15,435.50.

Taxpayers Who Claim The Standard Deduction

For the 2022 tax year, the standard deduction for a single filer is $12,950. Notably, the taxpayer receives the additional $6,000 deduction noted above for the IRA contribution. This deduction reduces the taxpayer’s gross income from $90,000 to $84,000. The deduction standard further reduces the taxpayer’s taxable income to $71,050. Hence, with the standard deduction, the taxpayer’s tax liability is $11,248 ($4,807.50 plus 22% of the excess over $41,775).

This is less than the amount of taxes owed after itemizing deductions. Even with a substantial mortgage interest deduction, the taxpayer would save $649 by opting for the standard deduction.

Compared To Itemized Deductions, Standard Deductions

In general, U.S. taxpayers will select between itemizing their deductions and taking the standard deduction, based on which option will decrease their taxable income the greatest.

Contrary to what many taxpayers may believe, they may profit most from the standard deduction because the TCJA roughly increased the amount of the standard deduction and eliminated (or capped) a large number of itemized deductions.

If you itemize, you must maintain receipts for qualified expenses and organize them by category throughout the year. During tax time, your total and list the expenses on Schedule A, and you keep the receipts in the event of an audit.

The standard deduction is far less cumbersome; you simply enter your standard deduction amount on line 12a of Form 1040 or Form 1040-SR.

State Income Tax Deductions

The majority of the 41 states that charge an income tax adhere as closely as possible to the format of the federal forms.

However, each state determines its own tax rates and basic deductions and may permit additional deductions or impose various limitations on deductions.

Some states prohibit itemizing state taxes for those who claim the federal tax deduction.

In any case, you should carefully review your state’s tax forms to determine if you qualify for any additional deductions. In New Mexico, for instance, you are exempt from state income tax at age 100. And Nevada residents who file their tax returns will receive a free deck of cards.

Restriction On Tax Deductions

Bear in mind that certain deductions are subject to limits. For instance, current federal tax law restricts the mortgage interest deduction to a maximum of $750,000 of secured mortgage debt (or $1 million if the home was purchased before December 16, 2017). This 2017 shift was a major blow to the extremely wealthy as well as those less-wealthy inhabitants of cities with the most costly residences.

Then there is the healthcare deduction limitation. If you itemize your medical expenses, the expenses you spent (for yourself, your spouse, and your dependents) must exceed a specific percentage of your adjusted gross income (AGI) in order to be tax deductible. The threshold for medical costs on your 2022 tax return is 7.5% of AGI for all taxpayers.

Capital Loss Transferability

Capital losses are an additional deduction not included in the regular or itemized tax deductions. They are reported on Schedule D with capital gains, as opposed to Schedule A.

A tax loss carryforward is a legal method of rearranging income for the benefit of the taxpayer. Individual and business capital losses from prior years can be carried forward. As with the 2022 tax year, you may deduct up to $3,000 ($1,500 if filing separately) in capital losses as a tax deduction (the tax return you file in 2023). If your losses exceed this threshold, you can “carry them forward” to the year or years that follow.

What Can I Deduct From My Taxes?

There are numerous tax deductions and credits that can be utilized to reduce your tax liability. Mortgage interest, retirement plan contributions, HSA payments, student loan interest, charitable contributions, medical and dental expenses, gaming losses, and state and local taxes are among the most prevalent tax deductions.

Common tax credits consist of the child tax credit, the earned income tax credit, the child and dependent care credit, the saver’s credit, the foreign tax credit, the American opportunity credit, the lifetime learning credit, and the premium tax credit.

How Can I Make The Most Of My Tax Deductions?

Contributing the maximum permissible amount to a typical (not Roth) retirement plan such as an IRA or 401(k) is advantageous whether you itemize or use the standard deduction (k). Hence, you will increase your retirement savings while minimizing your annual taxes.

If you have large mortgage interest, student loan interest, medical expenses, and other tax-deductible expenses, the sum may exceed the standard deduction. In such a circumstance, you can maximize your deductions by itemizing on Form 1040 or 1040-SR Schedule A.

What Is The Maximum Possible Tax Refund?

There is no upper limit. According to the IRS, the average direct deposit refund for people for the 2022 tax filing season was $3,121.

The Conclusion

A tax deduction is an amount that the Internal Revenue Service (IRS) permits taxpayers to deduct from their taxable income, thereby reducing their tax liability.

In their tax forms, taxpayers can either itemize the deductions to which they are entitled or opt for the standard deduction (a single amount). The strategy you select will likely be the one that reduces your tax liability the most.

The Tax Cuts and Jobs Act of 2017 roughly quadrupled the standard deduction, despite the fact that many taxpayers may believe itemizing is the superior strategy. Under specific conditions, it may cut your tax bill more than itemizing.