What are Tax Deductions? Definition and Common Examples
May 01, 2023
Let’s face it—while taxes help fund the programs that benefit the poor, the disabled, and the elderly, they also consume a significant chunk of your hard-earned income. This is where the benefits of tax deductions come into play.
With the prices of basic necessities going up, it is only natural to try and find ways to reduce the amount of taxes you owe and maximize what’s left of your income. But how do you do it? It’s simple—use tax deductions to your advantage.
So read this article to learn more about how tax deductions work and find viable ways to balance your expenses with your tax obligations!
- Tax deductions are specific items that are discounted from taxable income to reduce tax obligations.
- Common examples of tax deductions include mortgage interest, retirement and HSA contributions, interest on college education costs, charitable donations, etc.
- Self-employed individuals and small businesses share similar tax deductions, such as home office expenses, health insurance premiums, and internet and phone bills.
- Tax deductions and tax codes go hand in hand when accounting for potential losses and financial risks that affect a taxpayer’s income.
What is a Tax Deduction?
A tax deduction is any amount or portion of your taxable earnings that you can discount to help reduce the total taxes you owe. There are two ways to implement deductions on your taxes.
The first is through standard deduction, wherein a single fixed amount is deducted from your taxable income. The second requires itemizing all deductions on your Schedule A (Form 1040). Itemizing your tax deductions works best if you incur costs that outweigh the set deductions based on your filing status.
The Tax Cuts and Jobs Act (TCJA) recently implemented significant cutbacks in corporate tax rates while simultaneously pushing to increase the standard deductible tax amount. The standard deduction for single taxpayers for the 2023 tax year is $13,850, while for married couples, the amount was raised to $27,700.
Tax Deduction Example
Here are some concrete examples of how tax deductions work:
- A married couple files their tax return and claims tax deductions on expenses paid for their son’s tuition fees and other college costs. They will also itemize mortgage interest deductions.
- An independent contractor itemizes internet, phone, and home office improvement costs to reduce their taxable income.
- A business owner deducts 50% of expenses paid for their employees’ office snacks and meals. They will also include employee salary, benefits, and work-related travel expenses in their itemized tax deductions.
Common Tax Deductions
There are several types of tax deductions you can check and consider when filing your tax return, including:
#1. Charitable Donations
Charitable donations can be in the form of cash or noncash donations. The key to making charitable donations qualify for a tax deduction is to ensure that the item granted to the beneficiary is meant to help or assist them.
The IRS has specified acceptable donations and charities. Acceptable donations, such as cash gifts, properties, art, and investments, that exceed the commercial value of the goods provided are considered deductible from the donor’s federal tax return.
Acceptable charities are nonprofit organizations, foundations, or communities established in the US either for religious, volunteer, educational, scientific, literary, or public safety purposes.
#2. Retirement Contributions
There are specific limitations and provisions made by the Internal Revenue Service (IRS) for retirement contributions. The annual contribution limit for a 401(k) is set at $22,500 for 2023. If you want your IRA contributions to qualify for tax deductions later on, you’ll have to consider the type of IRA investment you’ve chosen.
For instance, in a traditional IRA, the deductions will be based on your Modified Average Gross Income (MAGI). At the same time, if the contributor is older than 50, their total contributions cannot exceed $7,000.
#3. Mortgage Interest Deduction
Mortgage interest deductions are a tax incentive for home or property owners, and they allow them to subtract their mortgage interest from their taxable earnings.
The TCJA also enforced changes in the deduction and loan limits for mortgages. Before the newly implemented loan limits, homeowners could deduct as much as $1 million. Now, the limit is set at $750,000.
#4. Self-Employment Expenses
Self-employment expenses comprise home office costs, health insurance premiums, business loans, and industry-related memberships and subscriptions.
Home office expenses only qualify if the home workstation is used exclusively for business or freelance work purposes. In the same manner, credit card interest incurred, including membership and subscription costs, should all be relevant to enhancing your business operations to qualify for a tax deduction.
#5. Interest on College Education Costs
This type of tax deduction applies to working students and parents. Some of the educational costs deemed deductible from taxes include tuition fees and books.
Note that student loan deductions are qualified for all filing statusesexcept married taxpayers filing separately.
#6. HSA Contributions
“HSA contributions” is a collective term that refers to qualified medical expense savings accounts that are paid pre-tax. You can fulfill your HSA contributions yourself or with the help of your employer.
Keep in mind that you must not be enrolled in Medicare to qualify for HSA contributions as deductions on your taxable income. At the same time, you cannot have any other type of healthcare coverage unless it is one that is permitted by the IRS.
Self-Employed Tax Deductions
Self-employed tax deductions offer several tax breaks that enable self-employed individuals to make the most of their profits. The said deductions are also applicable to independent contractors, freelancers, and even small business owners.
Since self-employed individuals do not have employers to share their tax contributions with, they pay their Social Security and Medicare taxes in full.
The thresholds for self-employed tax deductions differ per filing status:
- Single: $200,000
- Head of household with a qualifying individual: $200,000
- Married filing separately: $125,000
- Married filing jointly: $250,000
- Qualifying widow/widower with dependent child: $200,000
Small Business Tax Deductions
Some notable types of tax deductions for small businesses are as follows:
- Business interests and bank fees. Applies to interest generated from borrowing money to fund business operations.
- Salaries and benefits. Includes compensation and benefits (including vacation pay) given to employees. Employees must not be members of a partnership, an LLC, or a sole proprietorship.
- Educational expenses. Applies if you enroll in seminars, training, and any other educational courses to boost the skills and knowledge needed to enhance your business.
- Energy efficiency expenses. Any upgrades to a home office to reduce energy consumption enable small business owners to claim at least 30% of the incurred costs.
- Startup expenses. All expenditures associated with launching a new business, such as marketing, travel, and training costs, are tax deductible. As long as these startup costs were incurred in the latest tax year, you can deduct as much as $5,000.
Tax Deductions for 2022 vs. 2023 Tax Year
The table below exhibits a simple comparison of the tax deductions for the 2022 and 2023 tax years:
Tax Year 2022
Tax Year 2023
Married Filing Separately
Heads of Household
Married Filing Jointly
Surviving Spouses, Widows, or Widowers
How Can I Maximize My Tax Deductions?
The key to maximizing your tax deductions is to list down all possible deductions you can claim based on your employment and filing status. Use the examples below as a reference:
- 401(k) and HSA contributions. Try to contribute the maximum amount for your 401(k) and HSA premiums to increase the amount you save on taxes.
- Income. Postponing your income means putting off your income from the current tax year to the next. This method is only applicable if you do not have a fixed income, meaning your income rates vary annually.
- Unprofitable investments. It is crucial to take a closer look at your investments and pinpoint those that no longer merit significant financial gain. Unprofitable investments are classified as negative income, thereby diminishing the taxable percentage of your earnings.
Why are Tax Deductions Important for the Tax Code?
The tax code uses tax deductions to consider financial risks, losses, and other types of taxes imposed on an income. Let’s say a business owner has incurred marketing and training expenses to promote their business and enhance their services.
The logical way to address the added business costs is to discount the said expenses.
There needs to be a balance to ensure a taxpayer’s hard-earned money is not taxed more than once and that any losses incurred pre-tax are taken into account. Otherwise, there may be repetitive or multiple deductions on taxable income, which would then put taxpayers at a disadvantage.
Tax Deduction FAQ
#1. What is a tax deduction example?
Examples of tax deductions include health premiums, charitable donations, business loans, student loans, education expenses, 401(k) contributions, mortgage interest, and self-employment expenses.
#2. What is the difference between a tax exemption and a deduction?
A tax exemption refers to specific items or amounts that are spared or excluded from being taxed. Meanwhile, tax deductions are amounts that may be deducted from regular wages.
#3. How can I reduce my income tax?
Consider all the possible deductions that you can claim on your tax returns. For instance, if you are self-employed, you can deduct home office expenses and your phone and internet costs.
#4. Is tax exemption the same as a tax write-off?
Tax write-offs and tax deductions are the same. Both pertain to the items that you can deduct from your taxable income to help reduce your taxes owed.
Knowing your possible tax deductions is not a way to escape your tax obligations; rather, it shows how you, as a taxpayer, can have viable options to adjust your taxes owed to suit your specific financial status.
The key is to ensure that the discounted items you claim fall within the amounts and conditions set by the IRS.