Tax deductions are important aspects involved in the calculation of tax liability of any taxpayer. These are legally allowable deductions, as stipulated by different rules and regulations framed by IRS, which are used to calculate Adjusted Gross Income (AGI). The tax liability of the taxpayer is calculated on this AGI.
There are numerous allowable tax deductions that a taxpayer can avail. However, for the sake of brevity, we have presented here the most common deductions used by individuals. Broadly, a taxpayer has two options with regard to tax deductions, which he/she can exercise at his/her own discretion. As a common sense rule, the taxpayers invariably choose the option that allows maximum tax deductions to them.
Option I: Standard Deduction
Every year, IRS announces a fixed amount of standard deduction for different categories of taxpayers. Standard deduction is the most convenient form of assessing the allowable deduction. All you need to do is look for the standard deduction applicable for the category you belong to.
Option II: Itemized Deductions
Taxpayers have the option to go for itemized deductions if they believe that the itemized deductions will aggregate more than the Standard Deduction. The most common allowable itemized deductions include medical expenditure, education expenses, charitable contributions made to a 501(c)(3) qualified tax-exempt charity, donations to religious institutions (churches, temples, mosques, etc.), casualty and theft loss, mortgage interest, home mortgage points, local and State taxes, and other miscellaneous expenses.
Business Tax Deductions
Businesses are also allowed certain tax deductions that can reduce their tax liability. The most commonly availed business tax deductions include vehicle expenses for trucks, cars, and other vehicles used in connection with the business; travel expenses incurred by the taxpayer for work or business purposes; capital expenditure (other than business expenses); casualty losses; meals, entertainment and gifts in connection with the business; certain start-up expenses incurred for the establishment of a new business; home-office expenses, where the tax payer operates an office from home, etc.
Distinction between Tax Deductions and Tax Credits
Tax deductions and tax credits can be confused with each other. Therefore, its important to know the difference between the two in order to appreciate the subtle nuances of these two concepts.
A tax deduction is actually an expenditure incurred by the taxpayer that is ultimately subtracted from the income to avail tax benefit. A tax credit is dollar-to-dollar reduction from your actual tax liability unlike the tax deduction, which allows a percentage of amount expended and also a cap on deduction amount.
Tax deductions are reduced from the gross income of the taxpayer, but tax credits are allowed on the actual tax liability of the taxpayer.
After all the applicable deductions are subtracted from the gross income, taxpayers AGI remains upon which the tax liability is calculated.
Undoubtedly, tax credits translate into a better deal for the taxpayers, but it is equally difficult to qualify for the tax credits, while tax deductions are much easier to apply and claim reduction in tax liability.