Tax deduction
Also known as: tax write-off
A tax deduction is an amount subtracted from gross income before tax is calculated, reducing taxable income rather than the tax bill directly. Its dollar value depends on the taxpayer's marginal tax rate.
A tax deduction reduces the amount of income that is subject to tax. Unlike a tax credit, which cuts the tax bill dollar for dollar, a deduction's value depends on the taxpayer's marginal rate: a $1,000 deduction saves $220 for someone in a 22% bracket but $370 for someone in a 37% bracket.
Individual taxpayers claim deductions in layers. Certain "above-the-line" deductions — such as deductible traditional IRA or HSA contributions — reduce gross income to arrive at adjusted gross income (AGI). From there, taxpayers subtract either the standard deduction, a flat amount based on filing status, or the total of their itemized deductions, such as mortgage interest, state and local taxes (subject to limits), and charitable contributions — whichever is larger.
Businesses deduct the ordinary and necessary expenses of operating — wages, rent, supplies, depreciation — so that only net profit is taxed. Because tax law and financial accounting measure some deductions differently or in different years, companies track temporary and permanent differences between book income and taxable income, which is where deferred tax accounting comes from.
Tax deductions are tested across several exams: the IRS Special Enrollment Examination (SEE) Part 1 covers individual deductions in depth, the CMA Part 1 exam covers how tax deductions create deferred tax items in financial reporting, and the Series 6 touches on the deductibility of retirement and education plan contributions.
Key takeaways
- A deduction reduces taxable income; a credit reduces the tax itself dollar for dollar.
- A deduction's value equals the amount deducted multiplied by the taxpayer's marginal tax rate.
- Individuals choose the larger of the standard deduction or their itemized deductions after any above-the-line deductions.
- Businesses deduct ordinary and necessary expenses so that only net profit is taxed.
- The IRS SEE Part 1, CMA Part 1, and Series 6 exams all test deduction concepts from different angles.