'Deduction' is explained in detail and with examples in the Accounting edition of the Herold Financial Dictionary, which you can get from Amazon in Ebook or Paperback edition.
Deductions refer to any expenditure or other item which becomes subtracted from individuals’ total gross income. This deduction will naturally lower the aggregate total of income which must be subjected to annual income tax. Sometimes these are referred to as allowable deductions. As an example, any individuals who earn $50,000 and who are eligible to claim a $5,000 deduction would see their taxable income lowered to $45,000.
In the United States, the IRS Internal Revenue Service allows for a wide range of permissible deductions. Taxpayers may decide to either itemize their own specific personal deductions or instead claim the government provided standard deduction.
The IRS provides taxpayers with a standardized deduction amount of $6,300 for those who file as single, as of tax year 2016. Those who file as married filing jointly are entitled to a standard deduction of $12,600 instead. For those who file as head of household, the amount changes to $9,300 in that particular year. On any money earned under these income thresholds, the filers are not required to pay any income taxes. As an example, individuals who make $6,400 and who will claim the $6,300 standard deduction will only have $100 in income which is taxable.
Rather than taking these standardized deductions, those filing their taxes may instead choose to go with itemizing their own deductions. It means they take all of their permissible deductions and add them up together. They then can take this sum as the deduction instead of employing the standard deductions for use on the income tax return.
There are many popular itemized deductions. Among these are retirement account contributions, mortgage loans’ interest amounts, property taxes which individuals pay, educational expenses, child daycare expenses, and numerous others. For those who opt to take the standard deduction, a few itemized deductions may also be taken in concert with it. Some of these which are permissible include moving costs and interest on student loans which are eligible ones.
Business expenses should not be confused with deductions, though they function in much the same way. Any individuals who incur costs while pursuing profits in a business endeavor may deduct these from their business income. All of the relevant business income will still have to be reported to the IRS on the appropriate business income tax forms. The business expenses can be subtracted from the overall gross revenue. What remains is the net income. This means that business expenses function much as do deductions since they are taken off of the business earnings. Yet despite this, they are still not considered to be deductions.
Credits are similar to deductions in some ways. They also reduce the dollar amount of taxes which those filing have to pay. They do work differently however. Credits are instead subtracted from the aggregate taxes individuals owe instead of from the reported income. This is a critical difference that changes the amount of taxes which individuals must pay out directly. The IRS offers both nonrefundable and refundable credits to individuals and families. While nonrefundable credits cannot lead to a tax refund, refundable ones can do so.
An example helps to clarify these somewhat confusing points. In this scenario, if individuals report their income and claim all appropriate deductions, they still owe $1,000 in income taxes. These people could be eligible for a $1,200 tax credit. Should the credit not be refundable, the tax bill would be erased, but the extra $200 would be simply lost. When the credits are refundable instead, the filers would receive $200 as a tax refund. This means that they are actually paying a negative income tax thanks to these refundable credits.