Tax Deduction Basics

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One of the most confusing things to a taxpayer -other than how their income will be taxed in regard to tax rates and brackets – is how deductions affect their taxes.

People often assume that if they were to have say, $15,000 in deductions and their tax liability was say $21,000 that their new tax bill would be $6000.

However this is not the case at all. If the above scenario were true then that person would be receiving a tax credit.

In this article we'll explore how the basics of tax deductions work when calculating a person’s overall tax liability.

How Tax Deductions Work

Let’s assume we have an individual who makes $100.000 a year in income. Of that income that person is able to make deductions of $15,000 dollars.

So the taxable income for that person is now $100,000 – $15,000 or $85,000.

We now need to calculate what that person would owe in taxes.

Income Tax After Tax Deductions

Let’s look at what our taxpayer’s amount of liability would be before taking deductions

Bracket Amt Calculated Amount Owed
10%        $0 to $9,275 $9275 $927.50
15%        $9,275 to $37,650 $28375 $4256.25
25%        $37,650 to $91,150 $53500 $13375
28%        $91,150 to $190,150 $8850 $2478
  TTL $21036.75
  • post was written before new tax proposal.  Simply use this to get an idea of how deductions work. 

We see from the above table that the first $9275 is taxed at 10%.

We tax $28375 – the difference of $37650 and $9275 at 15% and $53.500 – the difference of $91150 and $37650 at 25%.

This has just edged into the 28% tax bracket so we subtract the lowest end of the bracket- $91,150 from $100,000 to get $8850.

The amount of all the brackets is equal to $21,036.75.

We will now take the $85,000 dollars of taxable income – our amount after deductions – and put it up against the tax brackets for 2016 to see what the overall tax liability for our tax payer is.

Bracket Amount Calculated Amount Owed
10%        $0 to $9,275 $9275 $927.50
15%        $9,275 to $37,650 $28375 $4256.25
25%        $37,650 to $91,150 $47350 $11837.50
28%        $91,150 to $190,150 $0 $0
  TTL $17021.25

So we can see that we have reduced our tax bill from $21,036.75 to $17,021.25.

This amount of the difference is $4,015.50 not $15,000.

And it’s really understandable where the confusion comes from. It is easy to assume the deduction will come off what is owed in taxes rather than simply reducing income.

However as you see from the above, if you shorted the total tax bill by $15,000 the US government would not be getting anywhere near the same amount of money.

Tax Deductions and Taxable Income

So we have seen how deductions work when calculating your taxes.

Subtract your deductions from your income to get at the taxable amount of that income.

This of course is a simplistic example. In reality there are calculations for what tax is owed on both a state and federal level. There are also rules for deductions – what percentage can be deducted and categories for example. I suggest doing your own taxes for at least one year. You will gain a better understanding of how your taxes are calculated. This will provide you with a greater intuition on how you should manage your finances. After all, you want to hold on to as much as possible.

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