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Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Standard Deduction

What it is:

A standard deduction is a reduction in taxable income. Federal, state and local tax codes determine what is deductible and which taxpayers are eligible for deductions.

How it works (Example):

There are two kinds of tax deductions: standard and itemized. A standard deduction is a flat amount that applies to all qualified taxpayers. An itemized deduction requires calculations, proof of a qualifying expense, and time to fill out extra IRS forms at tax time. A taxpayer cannot claim standard deductions and itemized deductions; he must choose one.

Generally, if a taxpayer qualifies for a standard deduction, the taxpayer can subtract the amount of the deduction from his gross income. This in turn lowers the amount of income subject to tax. For example, if your gross income is $100,000 this year but you qualify for a $10,000 standard 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 pay 20% of $90,000 ($18,000). The $10,000 tax deduction saves you $2,000.

Standard tax deductions are often promoted as tax deductions that apply to "everyone," but in fact they often "phase out" for people with higher incomes. After all, creating, modifying or eliminating tax deductions are one way for governments to encourage or discourage certain types of economic growth, social behavior or activities.

Why it Matters:

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. Though taking a standard deduction is easier and less time-consuming, when a person itemizes her deductions, she does so because she qualifies 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 accountant.

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