The Truth About Tax Deduction

by Jon Dulin · 16 comments

tax deductionsNow that tax season is upon us, many look for ways to reduce their taxes (hopefully most of you took advantage of some tax deductions before the end of the year). There is usually a mad rush to claim all of the deductions one can in order to reduce their tax liability. But are tax deductions really worth it?

Before getting into this discussion, I need to make a clarification between a tax credit and a tax deduction.

Tax Credit

This is an amount of money a taxpayer is able to subtract from the amount of money they owe the government. It is a dollar for dollar match. For example, the child tax credit reduces your taxes by the amount of the credit.

Tax Deduction

A tax deduction is an amount of money that lowers your tax liability by reducing your taxable income. For example, you can deduct student loan interest can be written off of you taxable income, thus reducing your tax liability.

Why Credits Are Better

If you are like many reading this, you may still be confused about what the difference is between the two. Don’t worry, as taxes are a complex topic and credits and deductions are as well. The key as to why credits are better are for the dollar for dollar match they provide. A tax deduction on the other hand, only reduces your taxable income and thus your tax liability proportionally, depending on the tax bracket you are in.

Real Life Example

Let’s use an example to clear this up. John makes $50,000 per year. This puts him squarely in the 25% tax bracket. As he is determining his taxes, he realizes he paid $2,000 in student loan interest last year, thus he gets a tax deduction. How much is his tax deduction? It is not $2,000. His tax deduction is the $2,000 in student loan interest he paid multiplied by the 25% tax bracket he is in. John can deduct $500 from his taxes. So, at the end of the day, John now has a taxable income of $49,500 (his original $50,000 less the $500 student loan deduction).

Mary on the other hand, also makes $50,000 per year and is in the 25% tax bracket. She does not have any student loans to reduce her taxes. However, there was a program this year where if you bought “green” appliance, you could take a credit for the amount of the appliance on your taxes, up to $1,000. Mary bought an energy efficient dishwasher that qualifies. It cost her $1,000. Because this is a credit, Mary can credit her taxable income by $1,000 (the amount she paid for the appliance). At the end of the day, Mary now has $49,000 in taxable income (her original $50,000 less the $1,000 credit).

Hopefully this shows you that any deduction you claim on your tax return only reduces your tax liability by the tax bracket you are in. If you are in the 25% tax bracket, every dollar you spend that is eligible for a deduction allows you to write off $0.25 of that dollar on your taxes. If you are in the 10% tax bracket, $0.10 of every dollar you spend that is eligible for a deduction will go towards reducing your tax liability.

Why Deductions Are Misleading

Even though you are getting a tax deduction, are you really saving any money? So many argue that you should take your time paying off your student loans because the interest you pay is tax deductible. That is true, but not every dollar. At most it’s $0.35 of every dollar because the highest tax bracket right now is 35%. Added to that, the majority of tax deductions have limits to not only the amount you can deduct, but also depend on what you earn. If you earn too much money, you cannot deduct any student loan interest. If you don’t earn too much and can claim the deduction, you can only deduct up to $2,500 in a year.

Revisiting John above, he is “saving” $0.25 of every dollar in interest he pays on his taxes. I will grant you that it is better than nothing, but wouldn’t you rather pay off the loan and be able to invest 100% of the money instead?

To put another way, in the end he paid $1,500 in student loan interest (the $2,000 he actually paid less the $500 he is able to deduct off of his tax return). He paid $1,500 in interest!

I am all for saving as much as you can on your taxes. But don’t be misled thinking that deductions will reduce your tax liability dollar for dollar. They won’t. Only credits do that.

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{ 16 comments… read them below or add one }

My Financial Independence Journey February 18, 2013 at 6:33 pm

The funny thing is that deductions and credits are probably some of the simpler parts of the tax code.

Although as a general rule I would be wary of any situation where you have to spend money in order to get a tax break. You might be better off not spending the money in the first place.
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moneysma February 20, 2013 at 8:06 pm

Very true!

Spending money to get a tax break is like falling for the buy more to save more trick.

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Mary Rhodes February 19, 2013 at 8:32 am

It’s definitely wise to ensure the fine print with deductions, my sister got done over here when she had deductions on an investment property. My advice is to keep all reciepts!
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moneysma February 20, 2013 at 8:05 pm

Especially with rental properties…the in’s and out’s of the tax code regarding those can be very confusing.

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John S @ Frugal Rules February 19, 2013 at 10:36 am

Great explanation of the two! I now it confuses a lot of people. Deductions can be a good thing, but like you said I’d much rather pay off that student loan to free up my money.
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moneysma February 20, 2013 at 8:04 pm

Many times when you do the math and realize you are “saving” only $0.25 while still paying $0.75 it makes it hard to argue that the deduction is worth it.

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Finance Inspired February 20, 2013 at 8:02 am

I always keep all my receipts, practically to the point of obsession! Tax can be confusing so great timing with the article…yet again.
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moneysma February 20, 2013 at 8:02 pm

I keep all of my receipts too. The key is to stay organized throughout the year so that come tax time you aren’t spending all of your time trying find and file receipts.

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Kim@Eyesonthedollar February 20, 2013 at 10:52 am

This was so going to be my post for Friday, and you beat me to it. Very good information. I know that credits are better,but still get confused on what is a credit and what is a deduction. Very good and simple explanations. I like the personal examples.
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moneysma February 20, 2013 at 7:56 pm

Thanks! It’s hard to try to make the tax code a simple matter.

Sorry about beating you to the post!

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Daniel February 22, 2013 at 2:18 pm

Taxes are never a reason to make any financial decision, with the exception of donating to charity. You shouldn’t need a reason to donate, but if donating $1,000 means you get $400 of that back when you file, then you might as well donate $1,667 and get back $667 when you file. More money donated makes you look really good!
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moneysma February 22, 2013 at 8:35 pm

This is one of the arguments for not eliminating or phasing out the charitable deduction. Many charities claim that many people will not donate without the tax incentive to do so. I’d like to think people would still donate, regardless if they save money on taxes or not.

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Jim February 23, 2013 at 8:39 am

moneysma,
Thanks for breaking taxable income down, I am going to the accountant on Tuesday to see what I can use to bring my taxable income down. This is very enlightening, thanks!
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julia @ howmuchcost.org September 23, 2013 at 2:35 am

That was a great break down. So when you claim dependents how does that work? I don’t have any kids and claim zero dependents and a LOT gets taken out of my check towards taxes and my friend claims 10 dependents and only gets $12 taken out of his pay check?? But at the end of the year will he owe more to the IRS anyways? I’d rather owe nothing to the IRS at the end of the year (by paying them out of each paycheck; I’d hate to find out I owed them and wasn’t expecting it) but I also don’t want to be paying them money I don’t have to. Do you know what I mean?
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Jon September 23, 2013 at 8:12 am

Great question! Claiming dependents will reduce the amount of taxes that are taken out of your paycheck. But, it you don’t claim a correct number, then you could end up owning much more or less come April 15th. Personally, when I was single and owned my own home, without kids, I claimed 2 dependents. Why? Since I could deduct my mortgage interest from my taxes, I was going to get a huge refund. By claiming more dependents, I reduced the amount of taxes I paid each week. In effect, I went from getting a huge refund to getting a small refund. I chose to get my money back in each paycheck instead of 1 big refund check from the IRS.

You can check out the IRS withholding calculator: http://www.irs.gov/Individuals/IRS-Withholding-Calculator to see how much you should withhold so that you are getting the biggest paycheck you can.

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julia @ howmuchcost.org September 23, 2013 at 10:28 pm

Oh. Okay that makes sense. Thanks. And that’s a great tip. I’m going to check out that calculator!
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