What Is a Tax Deductible?
A tax deductible is an expense that an individual taxpayer or a business can subtract fromadjusted gross income (AGI). The deductible expense reduces taxable income and therefore reduces the amount of income taxes owed.
Key Takeaways
- A deductible for taxes is an expense that a taxpayer or business can subtract from adjusted gross income, which reduces their taxable income, thereby reducing the amount of taxes owed.
- Most wage-earners use the standard deduction but those with very high deductible expenses can choose to itemize if that results in a smaller tax bill.
- The Internal Revenue Service (IRS) provides lists, requirements, and amounts of all available deductibles.
- Common deductions for individuals include student loan interest, self-employment expenses, charitable donations, and mortgage interest.
- Business deductibles include payroll, utilities, rent, leases, and other operational costs.
Deductible
Understanding Deductibles
Tax deductibles serve as incentives provided by governments to encourage certain behaviors. Governments tend to want people do things that are deemed beneficial to individuals or society as a whole. The purpose of tax deductibles is to reduce a taxpayer's taxable income, ultimately lowering their tax liability, if people do these things.
Specific tax deductibles are discussed more, but in general, governments want to promote specific actions such as charitable giving, investment in retirement savings, homeownership, education, and healthcare payments. The government wants people to engage in all of these as they contribute to economic growth, social welfare, and personal financial stability.
Additionally, tax deductibles can help individuals retain more of their hard-earned income. This also serves as the point of encouraging responsible financial planning. Individuals are incentivized via tax deductibles to continue earning wages and contributing a smaller amount of taxes that also contribute to society.
Advantages and Disadvantages of Tax Deductibles
Pros of Tax Deductibles
Tax deductibles offer several advantages for individuals and businesses. First, they serve as powerful incentives for specific behaviors. Not only is there a financial incentive for the taxpayer, but society can also benefit those help fostering economic growth, social welfare, and individual well-being.
The entire purpose of tax deductibles is to provide financial relief by lowering taxable income. By subtracting eligible expenses from their income, taxpayers can effectively retain more of their earnings. This had the added benefit of stimulating the economy, as the taxpayer now has greater disposable income they can pump into the economy.
Tax deductibles also have the benefit of promoting fairness and equity within the tax system. It recognizes and accounts for individual circ*mstances and responsibilities. For instance, deductions for medical expenses acknowledge the financial burden of healthcare costs, particularly for individuals with chronic illnesses or disabilities. Similarly, deductions for business expenses incentivize entrepreneurship and innovation (for those who may be creating jobs in your local community).
Cons of Tax Deductibles
Tax deductibles also have a number of downsides. Deductibles often contribute to complexity and inefficiency within the tax system. The proliferation of various deductions, each with its own eligibility criteria, limits, and rules, can make tax compliance burdensome for taxpayers and businesses. The complexity of tax deductibles can create opportunities for taxpayers to make many accidental tax errors.
Though it overlaps with an advantage, tax deductibles can exacerbate economic distortions by influencing individuals' financial decisions. For example, deductions for mortgage interest may incentivize excessive borrowing for homeownership, contributing to housing bubbles and financial instability. Similarly, deductions for certain business expenses may encourage wasteful spending or tax avoidance strategies that prioritize deductions over genuine business growth or productivity.
Last, though the promotion of equity was an advantage, tax deductibles can also exacerbate income inequality. There are opportunities for tax deductibles to disproportionately benefit higher-income individuals. For instance, think back to the mortgage interest deduction example. This tax deductible only impacts those who have the financial security of owning a home; therefore, someone struggling to make rent payments may not receive this tax benefit.
Tax Deductibles
Pros
Deductibles incentivize desired behaviors, fostering economic growth and welfare.
Lower taxable income offers financial relief and stimulates spending.
Deductions promote fairness by considering individual circ*mstances and responsibilities.
They encourage entrepreneurship and innovation while recognizing healthcare burdens.
Cons
Deductibles can increase tax system complexity.
Deductions influence financial decisions, potentially distorting markets.
Deductibles may worsen income inequality, favoring higher earners.
Complexity breeds errors, burdening taxpayers and businesses.
Standardized Deduction vs. Itemized Deduction
U.S. individual taxpayers may use either the standard deduction or fill out a list of all of their deductible expenses, depending on which results in a smaller taxable income Whether a taxpayer uses the standard deduction or itemizes deductible expenses, the amount is subtracted directly from adjusted gross income.
The vast majority of Americans have taken the standard deduction since 2018, when that figure was nearly doubled while many allowable deductions were eliminated or capped.
- For the 2023 tax year, the standard deduction for single taxpayers and married couples filing separately is $13,850. For married couples filing jointly, it is $27,700. For heads of households, it is $20,800.
- For the 2024 tax year, the standard deduction for single taxpayers and married couples filing separately is $14,600. For married couples filing jointly, it is $29,200. For heads of households, it is $21,900.
Tax Deductible: Itemized Deduction
Itemizing deductible expenses rather than taking the standard deduction requires filing one more piece of paper. A Schedule A form, used to record the various claimed deductions, must be attached to the main tax form, Form 1040 or Form 1040-SR.
The process requires a good deal of record-keeping throughout the year, including saving receipts or other proof of expenditures. Common itemized deductions include medical and dental expenses, state and local taxes, mortgage interest, charitable contributions, unreimbursed job expenses, and certain miscellaneous deductions like investment expenses or casualty losses.
Filers who take the standard deduction can file Form 1040. Those who are age 65 or older can use Form 1040-SR. It's nearly identical to Form 1040 but with larger print.
Business Deductibles
Business deductibles are considerably more complex than individual deductibles and require a great deal more record-keeping. A business or self-employed individual must list all of the income that was received and all of the expenses that were paid out in order to report the real profit of the business. That profit is the gross taxable income of the business.
Examples of ordinary business deductibles include payroll, utilities, rent, leases, and other operational costs. Additional deductibles include capital expenses such as depreciating equipment or real estate.
Permissible deductibles vary by the structure of the business. Limited-liability companies (LLCs) and corporations differ in the types and amounts of deductions available to their owners.
The standard deduction nearly doubled with the Tax Cuts and Jobs Act of 2017. In the first year of the Act's implementation, 2018, about 90% of taxpayers used the standard deduction rather than itemizing deductions.
Retirement Contributions
There are several types of retirement accounts that offer tax benefits, including Traditional IRAs, 401(k)s, 403(b)s, or SEP IRAs. Each type of account has its own eligibility requirements, contribution limits, and tax treatment.
The key point for this article is that contributions to certain retirement accounts can be tax-deductible. For example, if you earn $50,000 in a year and contribute $5,000 to a Traditional IRA, you can deduct the $5,000 from your taxable income.
The IRS sets annual contribution limits for retirement accounts, which can vary depending on the type of account and your age. For example, in 2024, the contribution limit for Traditional and Roth IRAs is $6,000 for individuals under age 50 and $7,000 for those age 50 and older (due to catch-up contributions). Employer-sponsored retirement plans like 401(k)s have higher contribution limits, often determined by the plan's terms and IRS regulations.
It's also important to note that the tax deductibility of contributions to retirement accounts may be subject to income limits and eligibility criteria. For instance, if you or your spouse are covered by a retirement plan at work, the tax deduction for Traditional IRA contributions may be reduced or phased out at certain income levels.
What's the Difference Between Tax Credit and Tax Deduction?
Both tax credits and tax deductions can help taxpayers pay less in taxes but there are distinct differences between the two.
A tax credit is a straight subtraction from your tax bill. For example, a $10 tax credit will reduce your tax bill by $10. A tax deduction lowers your taxable income, and therefore lowers the total amount you owe.
A tax deduction reduces your taxable income while a tax credit reduces your tax bill dollar-for-dollar.
How Are Tax Deductibles Calculated?
All tax deductibles (or the standard deduction) are subtracted from your gross income in order to arrive at an adjusted gross income, which is the amount that is subject to taxes.
Taxpayers who itemize deductions rather than taking the standard deduction add a Schedule A form to Form 1040. This form is used to list the expenses being deducted.
What Is the Standard Tax Deduction?
The standard deduction is a specific dollar amount that taxpayers may use to reduce their taxable income if they do not choose to itemize their deductible expenses.
- For 2023, the standard deduction for single taxpayers and married couples filing separately is $13,850. For married couples filing jointly, it is $27,700. For heads of households, it is $20,800.
- For 2024, the standard deduction for single taxpayers and married couples filing separately is $14,600. For married couples filing jointly, it is $29,200. For heads of households, it is $21,900.
Do Tax Deductions Increase Your Refund?
A tax deduction lowers your taxable income, which reduces your total amount of taxes owed. That can result in a refund if you overpaid taxes during the year.
Should I Take the Standard Deduction?
You should take the standard deduction or itemize deductions depending on which results in a lower tax bill.
You may have to estimate your allowable deductions, at least roughly, to figure that out. Also, keep in mind that you have to maintain records and receipts of deductible expenses throughout the year in order to back up the numbers you enter on Schedule A.
There may be some years when you have good reason to itemize your deductions. For example, if you have very high unreimbursed medical expenses for one year, they could amount to tax savings greater than the standard deduction.
The Bottom Line
A deductible is an expense that a taxpayer or business can subtract from adjusted gross income, reducing thus the amount of taxes they owe. The IRS provides lists, requirements, and amounts of all available deductibles.
Most taxpayers use the standard deduction when filing taxes, which for 2024 is $14,600 for single taxpayers and married couples filing separately, $29,200 for married couples filing jointly, and $21,900 for heads of households.
Taxpayers with very high deductible expenses may opt to itemize their deductibles. In that case, Schedule A form must be attached to the main tax form.
