What It Is:
A deduction is a reduction in taxable income, which thereby lowers the amount of taxes owed. Federal, state, and local tax codes determine what kinds of items or expenses are deductible and which taxpayers are eligible for deductions.
How It Works/Example:
For example, if your gross income is $100,000 this year but you qualify for a $10,000 deduction, then you will be taxed on $100,000 - $10,000 = $90,000. If your effective tax rate is, say, 20%, then instead of paying 20% of $100,000 (i.e., $20,000) you can take the deduction and only have to pay 20% of $90,000 ($18,000). The $10,000 tax deduction saves you $2,000.
Notice that a $10,000 tax deduction does not mean you save $10,000 in taxes. This is why it is important to understand the difference between a tax deduction and a tax credit. A tax credit is a dollar-for-dollar reduction in your tax bill. So, if the $10,000 deduction had actually been a tax credit in the example above, you would have paid ($100,000 x 0.20) - $10,000 = $10,000. Compare this with the $18,000 tax bill in the deduction scenario and you can see that tax credits are usually more valuable to taxpayers.
Tax deductions often "phase out" for people with higher incomes. For example, interest paid on student loans is deductible, but if a person's modified adjusted gross income was higher than $50,000 in 2006, only a portion of the interest paid was deductible. If the person's modified adjusted gross income was higher than $65,000, the person was probably not able to deduct any of it.
There are several kinds of tax deductions in the United States. Standard deductions are deductions taxpayers usually take advantage of if they don't qualify for other deductions. When a person "itemizes" his or her deductions, they do so because they qualify for several deductions that exceed the standard deduction. Deciding whether to itemize one's deductions is a matter of knowing the tax rules and consulting a qualified tax accountant.
Why It Matters:
Creating, modifying, or eliminating tax deductions are one way for governments to encourage or discourage certain types of economic growth, social behavior, or activities. For example, mortgage interest is tax deductible in part to encourage home ownership in the United States; tuition is often deductible to encourage education; charitable donations are deductible to encourage giving; and business expenses are deductible to encourage entrepreneurship and job creation.