A tax-deductible expense refers to a cost that can be subtracted from a taxpayer’s gross income when calculating their taxable income, thereby reducing the amount of income subject to taxation. Tax deductions are authorised by tax laws and regulations and designed to incentivise certain behaviours, activities, or expenditures that serve a public policy purpose or contribute to economic growth.
Key points about tax deductions include:
Reduction of Taxable Income: Tax deductions reduce a taxpayer’s taxable income by the amount of the deductible expense. For example, if a taxpayer earns $50,000 in gross income and has $5,000 in tax-deductible expenses, their taxable income would be reduced to $45,000.
Types of Deductible Expenses: Tax deductions can apply to various types of expenses, including business expenses, investment-related expenses, medical expenses, education expenses, charitable contributions, mortgage interest, property taxes, and certain retirement contributions. Each type of deduction may have specific eligibility criteria, limits, and documentation requirements.
Itemised Deductions vs. Standard Deduction: Taxpayers can claim either itemised deductions or the standard deduction when filing their tax returns, but not both. Itemised deductions involve listing individual deductible expenses on Schedule A of Form 1040, while the standard deduction is a predetermined amount based on the taxpayer’s filing status. Taxpayers choose the option that provides the greatest tax benefit.
Tax Benefits: Tax deductions reduce a taxpayer’s overall tax liability by lowering their taxable income, which results in a lower amount of tax owed. The tax savings from deductions can vary depending on the taxpayer’s marginal tax rate, with higher-income taxpayers generally benefiting more from deductions.
Limits and Phase-Outs: Some tax deductions may be subject to limits or phase-outs based on the taxpayer’s income level, filing status, or other factors. For example, certain itemised deductions, such as medical expenses and miscellaneous deductions, may be subject to an adjusted gross income (AGI) threshold before they can be claimed.
Record-Keeping: Taxpayers must maintain accurate records and documentation to substantiate their deductible expenses in case of an audit by tax authorities. This may include receipts, invoices, bank statements, and other supporting documentation to verify the nature and amount of the deductible expenses claimed.