What is a tax deduction & how does it work?

One of the best ways you can trim your tax bill is to develop a deeper understanding of the system—and that includes tax deductions. Being aware of how tax deductions work and what kinds might be available to you can be a big advantage when it comes time to file.

Here's what you need to know about these tax breaks to help minimize the amount you owe.

The amount of federal or state income tax you pay is based on the amount you earn throughout the year. Tax deductions—sometimes known as write-offs—are provisions that allow you to reduce the amount of your income that's taxable. That, in turn, reduces the total amount of tax you owe.

To claim a particular deduction, you must have incurred an eligible expense. Several types of deductions are possible, including those for contributing to health savings accounts, paying mortgage interest or running a small business. Depending on your circumstances, you may qualify for many deductions or none at all. This is where having some background knowledge on the topic, as well as working with a qualified tax professional, can help you get the most from your tax strategy.

Tax deductions are not the same as tax credits. Deductions reduce your taxable income. Tax credits reduce your tax bill on a dollar-for-dollar basis, making them somewhat more powerful than deductions. But claiming as many deductions as possible is still a vital way to whittle down the tax you owe—or increase the size of your refund if you overpaid during the year.

Suppose you're a single filer who earned $75,000 of income last year through employment. Without any deductions, the government would multiply the applicable tax rate by $75,000 to determine your annual tax liability. But imagine that you're eligible to claim $15,000 in deductions. Now, your taxable income has dipped to $60,000, so you pay a lot less to the IRS or your state tax authority.

Keep in mind that a deduction won't affect every taxpayer in the same way. That's because the federal government—and even some states—use marginal tax rates to determine how much income tax you owe. The more you earn, the higher your marginal tax rate will be.

The benefit you receive from a deduction depends on your tax bracket. If you make enough that you're well into the 35% bracket, for instance, a $5,000 deduction will result in a $1,750 reduction in your tax bill ($5,000 x 35% marginal tax rate). If you're in the 10% tax bracket, however, a $5,000 deduction will only cut your liability by $500 ($5,000 x 10% marginal rate).

Most tax deductions have to be claimed on Schedule A, Itemized Deductions, of your Form 1040. However, you can choose to take the standard deduction instead. This is a fixed amount you can subtract from your taxable income instead of itemizing. If the standard deduction exceeds your total deductions from Schedule A, you'll have a lower tax liability than if you don't itemize on your return.

The Tax Cuts and Jobs Act (TCJA), which went into effect in 2017, made a number of important changes to the tax code. One of them was nearly doubling the size of the standard deduction. With adjustments for inflation, the standard deduction is $29,200 for joint filers and $14,600 for those filing separately in 2024. For many taxpayers, it now makes more sense to claim this fixed amount rather than filing a Schedule A.

Take, for example, a married couple who has $20,000 in tax deductions—including state and local taxes, mortgage interest and charitable donations—from Schedule A. Because the standard deduction would reduce their taxable income by a larger amount than these itemized deductions, choosing the former would result in a lower tax bill.

Even if you take the standard deduction, however, you don't want to ignore deductions altogether. There are several write-offs—known as "above-the-line" deductions—you can claim whether or not you itemize. These include health savings account and individual retirement account (IRA) contributions up to allowable limits and the student loan interest deduction.

You should be aware, however, that the Tax Cuts and Jobs Act's provisions—including the elevated standard deduction—are set to expire at the end of 2025. Unless subsequent legislation prolongs that more generous standard deduction, it may make more sense for you to itemize in the future.

Understanding what you're eligible for can help you decide whether to itemize your deductions and how to make the most of your tax strategy. Among the various types of deductions available, these are the most commonly claimed. Some of these are considered above-the-line deductions, while others require you to itemize to take advantage of them.

• IRA contributions. The ability to write off contributions to a traditional IRA can provide a powerful boost to your retirement savings. The amount of this above-the-line deduction depends on your filing status, adjusted gross income and whether you're covered by a retirement plan at work.
• Pre-tax contributions to your 401(k), 403(b) and most 457(b)s. These are deducted from your gross income, and are another major tool in your retirement savings playbook. For 2024, you can write off up to $23,000, or $30,500 if you're age 50 or older, as long as your dollars aren't going into a Roth (post-tax) account. Plus, you can still claim this break even if you take the standard deduction because these deferrals reduce your gross income before any deductions are calculated.
• HSA contributions. Health savings accounts (HSAs) have multiple tax benefits, including the ability for you to deduct contributions up to the annual limit. To put funds into an HSA, however, you must be enrolled in a high-deductible health plan. Contributions from your paycheck reduce your gross income. If additional contributions are made by you or someone else separately, they are considered an above-the-line deduction, so you can claim them even if you don't itemize.
• Charitable donations. In general, you can write off contributions to charitable organizations up to 50% of your adjusted gross income. But that threshold may vary based on the type of organization you've supported. You must itemize to claim this deduction.
• State and local taxes. If you own your home and itemize deductions, you can write off taxes you paid to state and local governments. The deduction—which includes property, sales or income taxes—is capped at $10,000 a year.
• Mortgage interest. The mortgage interest deduction is another potentially valuable tax break for homeowners who itemize. In most cases, you can deduct interest on the first $750,000 of your housing debt—or $375,000 if you're married filing separately. If you bought your home before December 16, 2017, you can deduct interest on the first $1 million of your home loan.
• Business expenses. If you operate a business where income flows to your personal tax return, you can deduct the cost of eligible expenses on Schedule C. That means you can take these write-offs even if you claim the standard deduction. If you run a business out of a designated home office, you may also be able to claim the home office deduction.
• Student loan interest. You can write off the amount of interest you've paid on student loans, up to $2,500. This is an above-the-line deduction, however, the cap is gradually reduced and then eliminated if your modified adjusted gross income exceeds IRS limits.
• Medical expenses. You can deduct medical and dental costs that surpass 7.5% of your adjusted gross income, as long as you itemize and the expense was for you, your spouse or one of your dependents.
• Gambling losses. You have to report gambling wins as earnings for tax purposes. However, you can use any gambling losses you incurred during the year—up to, but not exceeding, the amount of your winnings, as an itemized deduction—to reduce your taxable income.
• Educator expenses. Teachers sometimes have to dig into their own pockets to pay for books and supplies. You can deduct up to $300 of unreimbursed expenses as an above-the-line deduction to help offset those costs.

Being aware of the various tax deductions you can claim is an important way to reduce your tax burden. However, using deductions wisely is just one part of an overall tax strategy. A financial advisor can help create a comprehensive, tax-efficient financial plan that allows you to keep more of what you earn.