Delving into Tax Deductions | WaterStone Bank

Ready or not, April 15 is coming! Whether you work with an accountant or do your taxes yourself, understanding the ins and outs can be a minefield.

Understanding tax deductions

One component of doing taxes that can be particularly confusing is the concept of tax deductions. A tax deduction is an expense that you can subtract from your income, reducing the amount you pay in taxes. Tax deductions lower your taxable income, helping you save money.

Charitable donations are the most common types of tax deductions as they reduce your taxable income by subtracting the amount of money you donated to charity. For example, if your annual income is $75,000 and you donate $3,000 to charity, you will be only taxed on $72,000.

Understanding tax credits

While tax deductions lower your taxable income, tax credits reduce the amount of tax you owe and cut your taxes dollar for dollar. Think about it this way—if you make $100,000 a year and have a tax deduction of $10,000, your taxable income is $90,000. If your tax rate is 25%, that’s a tax bill of $22,500.

Now, let’s say your income is still $100,000 a year, you don’t have any deductions, and your tax rate is 25%. That puts your calculated taxes at $25,000. However, you have a tax credit of $10,000, bringing your actual tax bill down to $15,000.

Tax credits can be either refundable or nonrefundable:

    • Nonrefundable: If you don’t owe much in taxes, it’s possible that you won’t be able to receive the full value of your credit. For example, a $500 tax bill and $1,000 credit won’t get you a $500 refund check—it just means you’ll owe $0 in taxes.
    • Refundable: Refundable tax credits include the earned income tax credit and the child tax credit. In these cases, if the value of your credit exceeds the amount you owe in taxes, you will receive a refund check.

Standard vs. itemized deductions

You have two options when it comes to tax deductions: standard deductions and itemized deductions.

    • Standard deductions: The IRS sets the standard deduction each year, and it’s the easiest option, especially if you’re doing your taxes yourself. If you choose to go this route, your taxable income is automatically reduced by a set amount based on how you file (single, married filing jointly, etc.).
    • Itemized deductions: With itemized deductions, you need to list each one of your deductions you’d like to claim ($50 to charity A, $100 to charity B, etc.). Itemizing can be a pain, but it’s worth it if you have enough deductions that will lower your taxable income more than the standard deduction.

Choosing the best option for you

How do you know whether a standard or itemized deduction is best for you? Standard deductions for 2023 are:

    • Single: $13,850
    • Married filing jointly: $27,700
    • Married filing separately: $13,850
    • Head of household: $20,800

Charitable donations aren’t the only things that are tax deductible. Other write-offs include:

    • Medical expenses: expenses that are more than 7.5% of your taxable income and weren’t covered by insurance
    • State and local taxes: the IRS allows people to choose whether or not they deduct state and local sales and income tax
    • Student loan interest: even if you don’t itemize, you can write off interest paid on student loans
    • Mortgage interest: you may deduct the interest you paid on up to $750,000 of mortgage debt
    • Retirement and investing: traditional IRA contributions are tax-deductible, but your deduction might be limited
    • Home office deduction: work-from-homers who set up a workspace used only for business can write off work-related expenses, including rent, utilities, and maintenance

The bottom line

So, which deduction is right for you? Most people take the standard deduction, but it can pay off—literally—to add up your itemized deductions before you make the final call. Would you save more by itemizing? Is the effort worth the time and payout, or is it easier for you to take the standard deduction and call it a day?

There’s no one-size-fits-all answer; it all depends on how complex your taxes are in a particular year. When in doubt, consult a tax expert who can point you in the right direction and help you better understand your individual tax situation.

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