How Tax Deductions Work: What you need to know to lower your tax bill

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Happy New Year! Starting in January, you should start receiving tax forms from banks and other institutions in order to prepare your taxes for last year. Tax season is the period between January 1st and April 15th when taxpayers prepare their financials from the previous year and submit their tax returns either on their own (with software like TurboTax or TaxAct) or with help from a professional accountant.  Each year, the laws change and it’s important to understand the most up to date guidance. Let’s talk about tax deductions – meaning, terms, basics and how tax deductions work.

Tax deductions – meaning behind the term.

tax deductions meaning behind the term

A tax deduction is a way to reduce your income and the amount that you’re taxed on, lowering your tax liability. You subtract your deductions from your income, making your taxable income lower. As you reduce your taxable income, you can lower your tax bill.

So what’s a Tax Credit?

A tax credit directly lowers your tax bill.

The difference between a tax deduction and a tax credit

 A $5,000 tax deductionA $5,000 tax credit
Adjusted Gross Income (AGI)$100,000$100,000
Subtract tax deduction($5,000) 
Taxable income$95,000$100,000
Tax Rate:24%24%
Calculated tax$22,800$24,000
Subtract tax credit ($5,000)
Total Tax Bill$22,800$19,000
Note that the above is a simple example showing the difference between a tax deduction and a tax credit. The United States has a progressive tax system that includes tax brackets by income level.

As you see from the example, a tax credit is more impactful to your tax bill.

How Tax Deductions Work: Claiming tax deductions

how tax deductions work - claiming tax deductions

You have the option to take the Standard deduction or itemize your deductions.

Standard tax deduction

The standard deduction is an amount that reduces your taxable income. Refer to the following chart to understand what your standard deduction would be.

Filing Status2021 tax year2022 tax year
Married, filing jointly$25,100$25,900
Married, filed separately$12,550$12,950
Head of Household$18,800$19,400

An example of how tax deductions work:

If you are single with no dependents (and no one claims you as a dependent) earning $60,000, the standard deduction reduces your taxable income by $12,550 for the 2021 tax year.

$60,000 (total income) – $12,550 (standard deduction) = $47,450 (total taxable income)

If you take the standard deduction, you can’t deduct other potential deductions including mortgage interest or some of the other popular deductions listed below.

Should I take the Standard Deduction?

  • If the standard deduction is lower than the sum of your itemized deductions, you should itemize.
    • Note: If you itemize, you need to have records in the event that the IRS audits you. Good record keeping is important
  • If the standard deduction is higher than the sum of your itemized deductions, then it might be better and easier to take the standard deduction.

The standard deduction has gone up significantly over the past few years so the best path depends on your individual situation.

Child Tax Credit

child tax credit

The child tax credit was created to help taxpayers support their families and is a tax benefit given to Americans in support of each qualifying dependent child.

For 2021 taxes, the credit is:

  • $3600 per child through age 5
  • $3000 per child ages 6-17
  • Dependents who are 18 years old may qualify for $500

The threshold for this credit is $150,000 for married filing jointly, $112,500 for heads of households, and $75,000 for all others.

Earned Income Tax Credit (EITC)

The Earned Income Tax Credit reduces the amount owed for low and moderate-income workers and families. For 2021 tax year, the earned income credit ranges from $1,502 to $6,728 depending on tax filing status, income, and number of children.

For the most up to date information, visit the IRS tables.

Lifetime Learning Credit (LLC)

american opportunity tax credit

The Lifetime Learning Credit helps tax payers pay for higher education including undergraduate, graduate, and professional degree courses.  

To qualify, your modified adjusted gross income (MAGI) must be lower than $58,000. The Lifetime Learning Credit is gradually reduced (you may receive a partial credit) for MAGI between $58,000 to $68,000. If you are filing jointly, your MAGI must be less than $118,000 for the full credit or you can receive a reduced amount for MAGIs between $118,000 and $138,000.

The credit is 20% of first $10,000 or up to $2,000.

American Opportunity Tax Credit (AOTC)

The American opportunity tax credit (AOTC) is a credit for qualified education expenses paid for an eligible student for the first four years of college or higher education.

To qualify, your modified adjusted gross income (MAGI) must be less than $80,000 (or $160,000 if filing jointly) for full credit and between $80,000 – $90,000 (or $160,000 to $180,000 if filing jointly) for partial credit.

The amount of the credit up to $2500 (100% of first $2,000 spent and 25% of next $2,000 spent on qualifying expenses).

This credit is also partially refundable; 40% of this credit (up to $1000) can be given as a tax refund.

Child and Dependent Care Credit

child and dependent care credit

The child and dependent care credit can be claimed if you paid expenses for the care of a qualifying individual to enable you (and your spouse, if filing jointly) to work or actively look for work.

The amount of the credit is a percentage of the amount of work-related expenses you paid to a care provider for the care of a qualifying individual. The percentage depends on your adjusted gross income.

For 2021, the total expenses that you may use to calculate the credit may not be more than $8,000 (for one qualifying individual) or $16,000 (for two or more qualifying individuals).

Saver’s Credit

Contributions to individual retirement account or employer sponsored retirement account – may qualify for the Retirement Savings Contributions Credit (Saver’s Credit).

To be eligible, you must be:

  • 18 years old
  • not a full-time student,
  • not claimed as a dependent on another person’s return

The amount of your credit depends on your adjusted gross income. For the most up to date information, visit the IRS website.

Property Taxes and State and Local Taxes

Property tax deduction is one of the key benefits of being a homeowner. You may deduct up to $10,000 ($5,000) if married filing separately) for property taxes, state and local taxes, and sales taxes. You might hear these taxes commonly referred to as SALT – State and Local Taxes.  

Mortgage Interest

how tax deductions work mortgage interest

Home Mortgage Interest can be deducted. Mortgage interest includes any interest you pay on a loan secured by your primary house (main home or a secondary home). This includes points which are prepaid interest. The limit is $750,000 – single filers and married couples filing jointly can deduct interest on up to $750,000 for a mortgage ($375,000 each if married filing separately).

Note there are some exceptions where mortgages taken out before Oct 13, 1987 is considered grandfathered and all interest is fully deductible. Any home purchased after Oct 13, 1987 and before Dec 16, 2017 is also eligible for the $1 million limit ($500,000 each if married and filing separately).

401(k) contributions

Contributions to qualified retirement plans, such as a traditional 401(k) plan, is made on a pre-tax basis and lowers your taxable income. There are limits:

  • In 2021, $19,500 ($26,000 total if you’re 50 or older)
  • In 2022, $20,500 ($27,000 total if you’re 50 or older)

Healthcare Savings Account Contributions

healthcare savings account contributions

You can claim a tax deduction for contributions you make (other than contributions made by your employer) to your high deductible health coverage.  You must have a high deductible health plan to benefit from this deduction.

In 2021, the limit is $3,600 for individuals and $7,200 for families (Taxpayers that are 55 or older can put in an extra $1,000)

For 2022, the contribution limit is $3,650 for individuals and $7,300 for families.

Student Loan Interest

how tax deductions work student loan interest

You can deduct up to $2,500 from your taxable income if you paid interest on student loans. The deduction is gradually reduced and eliminated by phaseout when your modified adjusted gross income (MAGI) reaches the annual limit for your filing status. For single filing status, your phase out starts at $70,000 and ends at $85,000. For married filed jointly, your phase out starts at $145,000 and ends at $175,000.

Charitable contributions

charitable contributions

In 2021, there are expanded tax benefits for charitable contributions. You can deduct up to $300 (or  $600 if married filing jointly) for cash donations, even if you itemize your deduction.


This post provided an explanation of tax deduction vs tax credit and then shared the most important tax deductions that you should know. This post should also help you better understand how tax deductions work.

The most popular tax deductions include:

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By Adam

Hey, I'm Adam. I started Wonder of Compounding in 2021 to help others learn about financial literacy and achieve their financial goals. I’m a lifelong student and eternal optimist with a passion for investing, technology and entrepreneurship. I’ve worked in the financial services industry for more than a decade. In 2008, I earned my Bachelor of Engineering and Master of Engineering from Stevens Institute of Technology and in 2015, I received my MBA from New York University.

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