How Do Tax Deductions Work?

Tax deductions can be above the line or below the line. What's the line?

Defining Tax Deductions

Tax deductions are actually a bit of a misnomer, as these are actually amounts subtracted from income and not from taxes owed. Tax deductions are amounts allowed by law for specific expenses incurred by taxpayers. These deductions are used reduce the amount of income that is taxed. Deductions are subtracted from a taxpayer's income before the amount of tax owed is calculated. Tax deductions should not be confused with tax credits, which are direct reductions in the amount of tax owed, not the amount of income being taxed.


Above and Below the Line Deductions

Above and below the line deductions are deductions that are made in parts of the tax form that appear above and below a physical line found on the federal forms such as Form 1040 and Form 1040A. In one part of the tax form, the taxpayer calculates their total income. The next section of the form allows the taxpayer to deduct certain expenses from this income. These deductions are known as above the line deductions and are deducted from total income to arrive at a figure called adjusted gross income. The taxpayer is then allowed to take below the line deductions from adjusted gross income in the form of either a standard or itemized deduction. After taking into account below the line deductions the taxpayer arrives at their amount of taxable income. The amount of federal income tax owed will be calculated based on this taxable income figure.


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Standard Deduction Versus Itemization

Taxpayers are allowed to itemize deductions. This means that the taxpayer can list all of their legally allowable deductions on a specific tax form called Schedule A. To avoid excess calculations and forms, taxpayers are also given the option of taking a standard deduction. Every year, a specific dollar amount is determined for each filing status. This amount is the standard deduction, or the amount of below the line deductions a taxpayer may take. Taking the standard deduction requires no forms, receipts or other proofs to be provided by the taxpayer. A taxpayer may take either the standard deduction or the itemized deduction, but not both. Taxpayers are, however, allowed to use whichever deduction method provides the highest deduction.


Changes in Allowable Deductions

The types and amounts of deductions that are allowed in any given tax year are constantly changing. It is important to make sure you understand the current year's laws before taking any tax deductions. While we have focused on federal deductions, state and local laws are often different from the federal laws. It is just as important to understand any state and local laws affecting deductions that can be claimed on those returns. If you are at all unsure about the deductions you may claim, be sure to contact a tax professional.