Understanding the Financial Basics of Tax Deductions
Before we dive into the specific deductions you might be missing, it’s crucial to understand a few fundamental concepts. Getting these basics right will empower you to make smarter decisions when you file your taxes.
Tax Deductions vs. Tax Credits
Many people use these terms interchangeably, but they are very different, and knowing the distinction is key. A tax deduction reduces your taxable income. The value of a deduction depends on your tax bracket.
Example: Let’s say you are in the 12% tax bracket and you find a $1,000 tax deduction. This deduction reduces your taxable income by $1,000, saving you $120 on your tax bill ($1,000 x 12%).
A tax credit, on the other hand, is a dollar-for-dollar reduction of your actual tax bill. This makes tax credits more valuable than deductions.
Example: A $1,000 tax credit reduces your tax bill by the full $1,000. It doesn’t matter which tax bracket you are in.
Standard Deduction vs. Itemized Deductions
When you file your federal income tax return, you have a choice: you can either take the standard deduction or you can itemize your deductions. You cannot do both. Your goal is to choose the option that gives you the largest deduction and, therefore, the lowest tax bill.
The standard deduction is a fixed dollar amount that you can subtract from your income. This amount is set by the IRS and varies based on your filing status (single, married filing jointly, etc.), your age, and whether you are blind. The good news for seniors is that the IRS provides a higher standard deduction for individuals who are age 65 or older.
Itemized deductions are a list of eligible expenses that you can total up and subtract from your income. These include things like medical expenses, state and local taxes, mortgage interest, and charitable donations. You should only itemize if the total of your eligible expenses is greater than the standard deduction amount for your filing status. For many seniors with significant medical costs, itemizing can lead to substantial savings.
What is Adjusted Gross Income (AGI)?
You will see the term “Adjusted Gross Income” or “AGI” mentioned often in tax discussions. Your AGI is your gross income (from all sources, like Social Security, pensions, and investments) minus certain specific “above-the-line” deductions. It’s a critical number because the ability to claim many itemized deductions, especially medical expenses, is based on a percentage of your AGI. A lower AGI can help you qualify for more deductions and credits.
