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Definition: Tax Deduction
Tax deductions are deductions to the taxable income that decrease the amount of tax owed to the government. The IRS classifies tax deductions into several categories. Above-the-line deductions are tax deductions that are subtracted from the gross income resulting in a value called the adjusted gross income (AGI). A standard deduction is a deduction on the AGI that is prescribed by the IRS on the basis of the filing status of the tax payer.
Itemized deductions are also deductions on the AGI that are deemed as expenses eligible for tax deductions by the IRS. Examples of itemized deductions include mortgage interest payments, medical and travel expenses, charitable donations, etc. The IRS prescribes restrictions on the amount of expenses that can be classified as deductibles.
For example, if a tax payer reporting $40,000 as taxable income, claims an annual mortgage interest payment of $10,000 as tax deductible, the AGI on which the tax amount will be calculated is $40,000 - $10,000 = $30,000. If the tax rate is 30%, the tax payer now has to pay $9,000 as tax payment as opposed to $12,000 without the tax deduction, thereby saving $3,000 in taxes.
Expenses that can be classified as tax deductions to be subtracted from the taxable income vary on the basis of the tax code specified by a particular region. Tax deductions encourage charitable expenses and provide an incentive for making contributions to public institutions by savings on tax payments. Tax deductions differ from tax credits. While tax deductions reduce the taxable income, tax credits are a direct deduction on the amount of tax due.