Deductions and exemptions are two important elements of our tax system. In order to manage your taxes successfully, it is important that you have an understanding of how both work and fit into the larger picture.
Deductions
Deductions are simply expenses that you can subtract from your adjusted gross income before you compute your taxable income. By lowering your taxable income you reduce the amount of taxes that you owe.
There are two ways to determine your deductions. Fortunately, you get to choose the method that gives you the most deductions. The two methods are:
- The standard deduction
- The itemized deduction
Note: Deductions and exemptions can become phased out as your income increases.
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Standard deduction
A standard deduction is the simplest way to go, which is a set amount that the government allows you to deduct. Most people who file a tax return will qualify for the standard deduction. If you do not earn a high income, live in a rented house or apartment, and lack unusually large deductible expenses, such as medical bills, state and local income taxes, or loss due to theft or catastrophe, you can probably file a standard deduction on your tax return.
- There is generally a fixed standard deduction you may claim based on your marital status, age or disability status.
- The amount is adjusted annually to account for inflation.
Itemized deductions
The second method of determining your allowable deductions is itemizing them on your tax return. This method requires more work but it can save you more money. These deductions must be listed separately and documented carefully. There are a number of common itemized deductions that you should be aware of, which include:
- Medical and dental expenses
- State, local and some foreign taxes
- Interest expenses
- Charitable donations
- Casualty and theft loss
- Job expenses
Click here for a full list.
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Itemizing Your Deductions
If the amount of your allowable deductions is greater than your standard deduction the IRS encourages you to itemize your deductions.
If you don't qualify for the standard deduction you have no choice but to itemize. Itemizing your deductions requires you to complete Schedule A of IRS Form 1040. It is a simple form to complete. However, be aware that your itemized deductions begin to phase out as your income level increases.
Your itemized deductions phase out at the rate of 3 percent of additional income. In other words, for each $1,000 of adjusted gross income above the phase out limits you lose $30 of itemized deductions. You can never lose more than 80 percent of your itemized deductions.
For more information about itemized deductions, see the instructions to Form 1040 on the IRS website.