Earning a substantial income is wonderful – until you realize how much of a percentage the Internal Revenue Service wants as its cut of your earnings. Fortunately, the IRS offers a lot of ways to reduce your taxable income and lower your tax bill. Some are mutually exclusive: you can't take both a credit and a deduction for the same thing. This still leaves a lot of opportunity for saving money at tax time, however.
You can take above-the-line deductions whether or not you itemize deductions: above-the-line deductions are adjustments that help determine your adjusted gross income. For example, if you pay alimony, it's income to your ex, which she must report. You don't also have to pay taxes on this money, so you can adjust your income by subtracting it. Other above-the-line deductions include contributions to health savings accounts and a few adjustments available to self-employed taxpayers. Student loan interest is an above-the-line deduction, as is tuition you've paid for yourself or a dependent. All these adjustments appear on lines 23 through 36 of your Form 1040; line 37 tells you your AGI. The income you ultimately pay taxes on begins with your AGI.
You can take deductions from your AGI on the second page of your 1040 return. This is where you claim exemptions for yourself, your spouse and your dependents: $3,800 each as of 2012. Complex rules determine who qualifies as your dependent, but the list typically includes your children if they live with you at least half the year, and relatives who depend on you for support and earn less than the exemption amount. You can deduct exemptions on line 42 of your 1040.
Standard or Itemized Deductions
In addition to claiming exemptions, you can take either the standard deduction or itemize your deductions to further whittle away at your taxable income. According to the IRS, most taxpayers choose the standard deduction. In many cases, it results in a greater deduction than if you itemize. It's $11,900 for married couples filing jointly in 2012 and $5,950 for single filers or spouses who file separately, and you can subtract this number from your AGI on line 40 of your 1040. If you elect to itemize instead, this involves completing Schedule A and submitting it with your tax return. Several expenses qualify as itemized deductions, such as mortgage interest, medical and dental costs, work-related expenses and charitable donations. Some are subject to a percentage rule, however – your total expenses must exceed a certain percentage of your AGI and you can only deduct the excess amount. If you elect to itemize, the total of your itemized deductions also appears on line 40 of your 1040 return.
After you've made all these deductions, the balance is your taxable income. The amount of tax you pay varies according to the tax bracket you fall into. You may not be done reducing your tax liability yet, however. After you figure out the tax you owe, you might be able to subtract credits from this amount if you qualify for any. Commonly used credits include those for education-related expenses for yourself or your dependents, as well as the child tax credit and the retirement savings contribution credit.
Beverly Bird has been writing professionally for over 30 years. She specializes in personal finance and w, bankruptcy, and she writes as the tax expert for The Balance.