What Is a Tax Write-Off in Simple Terms?
Demystify tax write-offs and learn how these deductions can effectively reduce your taxable income and tax bill.
A tax write-off, also known as a tax deduction, is an eligible expense subtracted from your gross income. This reduces the amount of income subject to taxes, thereby decreasing your overall tax responsibility.
How Tax Write-Offs Work
Tax write-offs reduce your taxable income, the amount of your earnings subject to tax. When you claim an eligible expense, that amount is removed from your total income before tax liability is calculated. For example, if you earn $60,000 and have $5,000 in eligible write-offs, your taxable income becomes $55,000.
You pay income tax only on this reduced figure. While a write-off is not a direct dollar-for-dollar reduction of your tax bill, it lowers the base on which your tax rate is applied. Actual tax savings depend on your specific tax bracket, as the deduction reduces income taxed at your highest marginal rate. Both individuals and businesses can use write-offs to manage tax obligations.
Everyday Tax Write-Offs
Many common expenses can serve as tax write-offs for individuals. Homeowners often benefit from deducting mortgage interest, which can represent a substantial write-off annually. Student loan interest paid on qualified education loans is another common deduction.
Individuals who itemize their deductions can also write off certain medical expenses that exceed a specific percentage of their adjusted gross income. Contributions to qualified charitable organizations, whether cash or property, are generally deductible. For those who pay state and local taxes, including income, sales, and property taxes, there is typically a deduction available.
Self-employed individuals and small business owners have a broader range of potential write-offs directly related to their business operations. Expenses for a dedicated home office can be deducted. Business mileage, the cost of supplies, equipment, and professional development courses are generally deductible. Self-employed individuals may deduct health insurance premiums.
Deductions Compared to Tax Credits
Understanding the distinction between tax deductions and tax credits is important for managing your tax liability. A tax deduction, which is what a write-off represents, reduces your taxable income. The actual tax savings from a deduction depend on your tax bracket; a $1,000 deduction for someone in the 22% tax bracket would result in $220 in tax savings. This means deductions reduce the income that is subject to tax, rather than directly reducing the tax itself.
In contrast, a tax credit directly reduces the amount of tax you owe, dollar-for-dollar. If you have a $1,000 tax credit, your tax bill is reduced by exactly $1,000. Tax credits are generally more advantageous than deductions because they provide a direct reduction of your tax liability, regardless of your tax bracket. While deductions lower the income base, credits directly chip away at the final tax amount due.
Documenting Your Write-Offs
Maintaining thorough and accurate records for all claimed tax write-offs is important for compliance and potential verification. The Internal Revenue Service (IRS) requires taxpayers to substantiate their deductions, and proper documentation serves as proof of your eligible expenses. This helps ensure that if your tax return is ever reviewed, you can provide the necessary evidence to support your claims.
Records should include receipts, invoices, canceled checks, and bank statements that clearly show the date, amount, and purpose of each expense. For business-related deductions like mileage, a detailed log noting dates, destinations, and purposes of trips is often necessary. Organizing these documents, whether in physical folders or digital files, allows for easy retrieval and helps ensure you have a complete record of your deductible expenses.