About 90% of Americans don’t understand the tax code. You could be paying more in taxes than you should simply because you don’t know how taxes work.
The way to limit your tax burden is through tax deductions and tax credits. You are likely to have tax deductible expenses if you have a home or own a business.
What does tax deductible mean and how can that impact your taxes? Keep reading to discover important information that can help you save money on your taxes.
Tax System Basics
The way our tax system works is that you pay a percentage of your income towards federal and state income taxes. The United States has a progressive tax system, so the percentage of income taxes paid depends on your earnings and your filing status.
You also pay 6.2% of your earnings to Social Security and 1.45% to Medicare. These are social programs that you’ll be able to receive benefits from when you are 65 or older.
The taxes are withheld from your paycheck according to the IRS withholding table and how many exemptions you put down on your W-4 Form.
The easiest thing to do is to take a look at a calculator that can estimate your withholdings for you.
What Does Tax Deductible Mean?
When you file your taxes, you reconcile how much you already paid in taxes from your earnings and tax credits and deductions. You’re then taxed based on your Adjusted Gross Income (AGI).
The lower your AGI, the less you’ll pay in taxes. Ideally, you want to have as many tax deductible expenses as you can.
Here’s an example of a tax deductible expense. You earn $70,000 a year. You have qualified business expenses that total $15,000. Your AGI becomes $55,000.
You have a choice when you file your taxes. You either take the standard deduction, or you can itemize your deductions, which you would do on a Schedule A.
In the Tax Cuts and Jobs Act of 2017, the standard deduction was doubled. For the year 2020, the standard deduction is $12,400 for single tax filers and those married filing separately. Married couples that file jointly have a $24,800 standard deduction.
Your personal tax deductions would have to be more than the standard deduction to make it worthwhile.
Tax Deduction vs. Tax Credit
What is a tax credit and how does that differ from a tax deduction? As you just learned, a tax deduction will lower your AGI and can put you in a lower income tax bracket.
A tax credit is applied to the amount of taxes you owe. For example, if you owed $5,000 in income taxes and you received a $1,000 tax credit, your tax bill is lowered to $4,000.
The Importance of Learning the Tax Code
Understanding the tax code has its advantages. Knowing basic terms like tax credits and tax deductible can make a huge difference in your tax bill.
What does tax deductible mean? It means you can subtract qualified expenses from your total earnings.
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