Tax Deductions - What Does That Really Mean?

Our tax system would have a pretty hard time being more complex. If you are like most Americans, you hear terms like tax deductions, tax credit, adjusted gross income and you want to know more, but you never really do any research. It is not until you really need to know what a tax term means that you finally pay attention and figure it out. What if you found out that you may be paying more taxes because these terms? Would you want to know more? I thought so.

Let's start with the basics. A tax deduction is something that lowers your tax liability. In other words, a deduction allows you to take some amount of your income for the year and not have to pay taxes on it. If you paid taxes on 30% of your income, a deduction of $1000 saves you that 30% you would have paid or $300. Tax deductions are often confused with tax credits. A credit comes straight off of the taxes you pay. So rather than saving 30% of your money, you save 100% of that money.

A tax deduction helps you lower your adjusted gross income. To define adjusted gross income, it is simply the amount of income you have after you have subtracted all of your deductions. Why does this matter? Your tax bracket is determined by your adjusted gross income and not your total income. The more deductions you have, the lower your adjusted gross income will be, and the lower tax bracket in which you will be. Tax brackets are important because the higher bracket you are in, the higher percentage of taxes you will pay.

Let's work through an example. The 2008 federal tax brackets say that taxpayers filing with a status of single will pay 10% on all income between $0 and $8, 025. They will pay 15% on all income between $8, 025 and $32, 550. If they fall into the 15% tax bracket, they will also pay the 10% on the $8, 025. For our example, we will say that Mike makes $20, 025. Taking no deductions into account, Mike would pay his 10% for the first bracket or $802.50. Mike would also pay 15% on the rest (20, 025 - 8, 025) * 15% = $1800. Add those together and Mike pays $2602.50 in taxes. Ouch! Deductions would have helped Mike. Here is how.

Mike owns his house. He pays a mortgage. One tax deduction available to homeowners is that all interest paid on the mortgage is tax deductible. You can see that in order for Mike to get into the lower tax bracket completely, he would need $12, 000 in deductions. However, every dollar of tax deduction he does have is less he pays at the higher 15%. If Mike paid $6, 000 in mortgage interest last year, he can deduct that and bring his adjusted gross income down to $14, 025. Now the amount he pays at 15% is (14, 025 - 8, 025) or $6, 000 instead of $12, 000. He pays $900 instead of $1800. He saved $900 in taxes! If Mike would have paid that $6, 000 in rent instead of to a mortgage, he would have paid Uncle Sam $900 extra dollars.

Some common places to watch out for tax deductions or other items that lower your adjusted gross income are 401K plans at work, charitable contributions, child-care costs, vehicle license tax, interest on first and second mortgages, losses on investments, interest paid on student loans, property taxes and contributions to IRAs.

Using tools such as TurboTax and TaxAct will help you make sure you don't miss out on any tax deduction to which you are entitled. Click here to file your federal return for FREE.

Don't forget April 15th is the deadline!