A tax deduction reduces a taxpayer’s total income which in turn, decreases the amount of money owed to the taxing government agency. In essence, tax deductions are breaks granted by the government levying the tax.
The deductions does not tangibly reduce an individuals income, but instead, reduces the percentage tax that is dependent upon the income bracket that the taxpayer falls under.
Tax deductions differ from tax credits, because a tax deduction reduces the individuals taxable income, whereas a tax credit is an amount of money offered to the taxpayer from withholding wages throughout the taxable year.
If an individual, for example, has $50,000 worth of taxable income, and they receive a $1,000 tax deduction, their taxable income decreases to $49,000. The individual does not save $1,000; the government taxes the $49,000 income as oppose to the previous $50,000.
The decreased income yields a smaller percentage tax payment to the government. In contrast, a tax credit in the same situation would reduce the amount of taxes by $1,000. The actual savings is therefore equal to the tax credit.
In the United States tax system the amount levied is related to the individual’s tax bracket. Individuals with low incomes are taxed at lower rates; as income rises, the proportionate tax-rate percentages rise.
Tax deductions are used to lower taxable income to the point that the individual’s tax bracket may fall to a lower percentage rate. The current system allows for numerous tax deductions; certain deductions are available for individuals and businesses.
Interest on specific loans (mortgages and equity loans), educational expenses, state and local taxes, charitable donations, tax advice, moving expenses, and capital losses are all tax-deductible items.