Whether you are an employer or an employee, understanding the numbers on your paycheck and income tax form is an advantage.. Knowing the meaning of key terms is a good start. Have you ever wondered what a deduction is?
What does a “deduction” mean on an income tax form?
A deduction refers to an expense that a taxpaying individual or business can subtract from their gross income. By taking some deductions out of the gross income, the amount of income that is subject to tax is thereby reduced. Consequently, reducing the taxable income also reduces the taxes owed to the federal government.
Dianne earns $52,000 from her corporate job and donated $2,000 to a charity she believes in. In the same year, Dianne is eligible to claim a deduction for that donation she made. With the deduction, her taxable income becomes $50,000.
Is a deduction the same as a tax credit?
No, they are not the same. Note that a deduction is subtracted from gross income and reduces the income that is subject to tax. On the other hand, a tax credit reduces the amount of tax that is owed.
What is the significance of deductions on taxes?
A tax deduction is subtracted from gross income which makes the taxable income lower. In effect, this also reduces the taxes owed. Remember that the lower the taxable income, the lower the tax liability.
Let’s say Jan has $50,000 income for a year and makes a charity donation of $3,000. Jan can deduct $3,000 from his taxable income. So, Jan’s taxes will be based on a taxable income of $47,000 instead of $50,000.
In the United States, individual taxpayers are given the option of either claiming the standard deduction or itemizing their deductions. While the taxpayer is allowed to choose freely between the two options, the decision is usually based on which option is larger.
As mentioned, the larger the deduction, the lower the taxable income. If the standard deduction amount is less than the itemized deductions combined, then itemizing deductions will be more beneficial. Similarly, if the standard deduction is larger than the sum of the itemized deductions, then it is more helpful to go with the standard deduction.
In comparison, claiming the standard deduction is a simpler process than itemizing. However, this is again up to the taxpayer to decide. For businesses, there is no standard deduction. They must report all their gross income and deduct all business expenses to determine their taxable income.
What are examples of deductions?
The list of tax deductibles can change year per year and can vary depending on the taxpayer’s income bracket. To be sure, you can consult with a tax preparer to go through your possible deductions more thoroughly when preparing your taxes.
The following are examples of common personal deductions:
· Home mortgage interest
· Property, state, and local income taxes
· Investment interest expense
· Medical expenses
· Charitable contributions
· IRA contributions
· Work-related education expenses
For businesses, the following are an example of commonly deductible expenses:
· Salaries and wages
· Asset depreciation
· Professional services
· Freelance/independent contract labor
· Work opportunity tax credit
· Office supplies and expenses
· Client and employee entertainment
· Employee benefits
· Furniture and equipment
· Computer software
· Business location rent
· Business travel expenses
· Loan interest
· Equipment/Machinery rental
· Employee education and child care expenses
· Bank charges
· Disaster and theft losses
What is a payroll deduction?
A payroll deduction is an amount that is taken out from an employee’s paycheck. An employer removes a predetermined amount from an employee’s paycheck to pay for different benefits such as health insurance premiums, retirement plans, life insurance premiums, etc. It is important to note that payroll deductions are made by an employer with the consent of the employee.
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