How Do Tax Deductions Work?

As the end of the year approaches, it’s important to start thinking about your 2022 tax bill. There are a variety of deductions you can make when you file your taxes, which can help to lower your overall tax liability.

So, how do tax deductions work? Let’s look at deductions for taxes, including tax deductions for homeowners and pre-tax deductions.

What Is a Tax Deduction?

A tax deduction is an expense that you may deduct from your taxable income, thereby reducing the amount of tax you must pay. Tax deductions could help you save hundreds or even thousands of dollars every year.

For example, if you make a charitable donation to a charity last year, you may write it off and reduce the amount of tax you must pay for the tax year. So if your income for the year was $40,000 and you gave $2,000 to a charity, your taxable income is $38,000.

Tax Deductions vs Tax Credits

A tax deduction will reduce your taxable income while a tax credit will save you on your taxes dollar for dollar. Here’s an example:

You get a $2,000 tax credit which cuts your tax bill by $2,000 for the year. Tax deductions are a bit more complicated; say you fall within the 22% tax bracket, then you will get a reduction in your taxable income of $440.

Tax credits can either be nonrefundable or refundable. So if you get a refundable tax credit of $400 but you owe $100 in taxes, you will get a check for $300. If your tax credit is nonrefundable, you won’t be getting that check.

Types of Tax Deductions

Standard Deductions

One of the most common deductions is the standard deduction. For the 2023 tax year, the standard deduction for single filers is $13,850, and for married couples filing jointly, it is $27,700.

This deduction can be taken regardless of whether or not you itemize your deductions.

State and Local Taxes

Another popular deduction is the state and local taxes (SALT) deduction. This allows you to deduct state and local income, sales, and property taxes up to a combined limit of $10,000.

This deduction can help to lower your overall tax liability, especially if you live in a state with high taxes.

Mortgage Interest

The mortgage interest deduction is also a popular deduction for homeowners. You can deduct the interest you pay on your mortgage, up to a limit of $750,000 for mortgages taken out after December 15, 2017.

This deduction can help to lower your overall tax liability, especially if you have a high mortgage balance.

Pre-Tax Deductions

Pre-tax deductions in the US are deductions from your gross income that are taken out before taxes are calculated.

These deductions can lower your taxable income and therefore reduce the amount of taxes you owe.

Some common pre-tax deductions include:

401(k) contributions: If you contribute to a 401(k) retirement plan through your employer, the money is deducted from your paycheck before taxes are calculated.
Health insurance premiums: If you have health insurance through your employer, your premiums may be deducted from your paycheck before taxes are calculated.
Flexible Spending Account (FSA) contributions: FSAs are accounts that allow you to set aside pre-tax dollars to pay for eligible medical, dental, and vision expenses.
Dependent care expenses: If you have dependent care expenses, such as childcare or eldercare, you may be able to set aside pre-tax dollars to pay for these expenses.
Transportation expenses: Some employers offer pre-tax deductions for transportation expenses, such as parking or public transportation costs.

It’s important to note that pre-tax deductions can lower your taxable income, but they may also affect your take-home pay.

There are also limits to how much you can contribute to certain pre-tax accounts, so it’s important to understand the rules and regulations around these deductions.

Tax Deductions for Homeowners

As a homeowner in the US, there are several tax deductions that you may be eligible for.

In addition to mortgage interest as explained above, here are some of the most common ones:

Property tax deduction: Homeowners can deduct the property taxes they pay on their primary residence and any additional properties they own.
Home office deduction: If you use a portion of your home exclusively for business purposes, you may be able to deduct expenses related to that space, such as a portion of your mortgage interest, property taxes, and utilities.
Energy-efficient upgrades deduction: Homeowners can claim a tax credit for installing certain energy-efficient upgrades, such as solar panels or a geothermal heat pump.
Home improvement loan interest deduction: If you take out a home improvement loan to make improvements to your home, you may be able to deduct the interest paid on the loan.
Casualty loss deduction: If your home is damaged or destroyed by a sudden, unexpected event, such as a fire or natural disaster, you may be able to deduct some of the repair costs.

It’s important to note that tax laws can change and it’s always best to consult a tax professional or accountant for specific advice related to your individual situation.

Investing and Retirement

Your contributions to a traditional IRA are likely tax-deductible but you might be limited to what you can deduct based on your income.

However, if you take money out of your IRA, you will have to pay taxes on it. This is why many financial advisors recommend investing in a Roth IRA as that is funded with after-tax income. You won’t be able to deduct your contributions from tax though, but it may just be a better way to invest for your retirement.

Other Deductions

If you make charitable contributions, you can also deduct them from your tax return.
You can deduct donations of cash and donations of property such as clothing or household items.
You can also deduct certain expenses related to your job, such as unreimbursed business expenses, or certain education expenses, like tuition and fees.

It’s important to note that these deductions can change from year to year and it’s always best to consult a tax professional or IRS guidelines to ensure you are taking advantage of all the deductions you qualify for.

Keep in mind that taking these deductions can help lower your overall tax liability, but it’s important to consult with a tax professional to avoid any errors on your tax return that could lead to penalties or fines.

In summary, many deductions are available when you file your 2022 taxes, such as the standard deduction, state, and local taxes deduction, mortgage interest deduction, charitable contributions, and certain job and education expenses.

Be sure to consult a tax professional or use tax software to ensure you are taking advantage of all the deductions you qualify for.

Tax Deductions – FAQs

How do deductions affect refunds?

Tax deductions reduce your total taxable income on your tax return and thereby reducing the amount of tax you owe. This means deductions can either increase or decrease your tax refund.

A tax deduction reduces your adjusted gross income or AGI and thus your taxable income on your tax return. As a result, this either increases your tax refund or reduces your taxes owed.