How do tax write-offs work?
We all know the saying: “There are two certainties in life: death and taxes.” Since taxes are one of our largest ongoing expenses, we’re all interested in keeping them as low as possible. Fortunately, the government has created tax breaks in order to incentive citizens to do things it considers valuable to society.
For example, the government wants people to buy homes, have children, donate to charity, and start businesses. Thus, the government established the mortgage interest deduction, child tax credit, and charitable deduction, and all business expenses are deductible against business income.
It’s important to be aware of these tax benefits when making decisions. Any money that doesn’t go to taxes can be put toward your other financial goals.
How tax deductions work
You can subtract tax deductible expenses from your taxable income. Since your taxable income is lower, you could pay less taxes.
Let’s assume a married couple is in the 12% tax bracket (combined income between $19,750 and $80,250). A $1,000 tax-deductible expense would lower their taxable income by $1,000. Since the couple wouldn’t owe taxes on that $1,000 of income, they would save $120 in taxes (12% of $1,000) that they otherwise would have owed.
It’s important to understand that tax deductions lower your taxable income, not taxes owed. Have you heard anyone say, “It’s okay if I spend that money because I can write it off on my taxes”? Some people treat tax deductions as if they are getting their money back. A more accurate way to look at a tax-deductible expense is that the government provides a percentage subsidy of that expense equaling your marginal tax rate.
So in the case of this example couple, the government subsidized 12% of that $1,000 expense and the couple’s taxes were lowered by $120 (12% of $1,000). Not bad, but not the same as a 100% subsidy.
Tax deductions vs. tax credits
Unlike tax deductions, tax credits decrease taxes owed dollar-for-dollar. For instance, if that same married couple above had a child, they could claim the child tax credit ($2,000 per child). Let’s say they had a combined taxable income of $60,000 and would ordinarily owe $7,000 in federal income taxes. The child tax credit would lower their tax owed to $5,000.
So which is better, tax deductions or tax credits? It depends on your tax bracket. Taxpayers in lower brackets often benefit more from tax credits, while taxpayers in higher brackets tend to benefit more from tax deductions. For instance, our example couple would need $16,667 in tax deductions to save $2,000 in taxes (12% of $16,667 = $2,000). Let’s compare that to another couple earning $350,000, putting them in the 32% bracket. That couple would only need $6,250 in tax deductions to save $2,000 in taxes (32% of $6,250 = $2,000).
Standard deduction, itemized deductions, and above-the-line deductions
Since the new tax bill passed, it’s even more important to pay attention to whether you itemize deductions or take the standard deduction. The IRS grants every taxpayer a no-questions-asked standard deduction amount. You can either claim the standard deduction or itemize your deductions and claim that amount. You cannot do both. After adding up your deductible expenses for the year, if that total is larger than the standard deduction, it makes sense to itemize. If your total itemized deductions are lower than the standard deduction, then you should take the standard deduction.
The 2017 Tax Cuts and Jobs Act (TCJA) doubled the standard deduction. It is now $12,400 for single taxpayers and $24,800 for married couples. After this change, a lot of taxpayers who usually itemized have found that it’s no longer in their interests. An estimated 13.7% of taxpayers will itemize in 2019 compared to 31.1% if pre-TCJA law were still in effect. This means you may no longer be getting tax benefits from some of your expenses, which increases the real cost of those expenses to you.
Lastly, above-the-line deductions can be used whether you itemize or not, so they are very valuable.
Using this knowledge throughout the year
When you understand how tax deductions work, you can think about them not just at tax time, but also proactively. You can think about how the decisions you make today will impact your future tax bill.
For instance, in 2025, the standard deduction amounts are set to return to where they were before (essentially cut in half). Today’s larger standard deduction has caused some of you to start claiming that when you previously itemized. In that case, it could make sense to delay 2024 deductible expenses ( medical bills or charitable donations) into 2025. You will likely claim the larger TCJA standard deduction in 2024 either way, so those expenses provide no tax benefits. Spending that money in 2025 would provide additional deductions, because you would likely be back to itemizing after the standard deduction goes back down.
James Mwombela is a Certified Financial Planner™ professional who helps clients make educated financial decisions in order to live their best lives. He began learning everything he could about managing finances during college in order to have more financial stability than he experienced growing up. He became determined to share this knowledge with others so they could experience the same confidence and freedom of choice.