Your tax deductions do not come directly off of your tax bill. In other words, if you owed $1,000 in taxes and deducted a $100 expense, you would not reduce your taxes to $900. Instead, tax deductions reduce your taxable income. That means you calculate your gross income for the year and then subtract expenses before figuring your taxes. If you earned $50,000 and deducted a $100 expense, you would pay taxes on $49, 900. The amount a deduction saves you in taxes depends on your tax bracket.
Your Marginal Tax Rate
You do not pay one tax rate. If you had a 28 percent marginal tax rate in 2012, for example, you would have only paid the 28 percent tax on any income over $85,650. Suppose you earned $86,750 that year: you would only pay 28 percent on the last $100 you earned. The same graduated percentages apply to each tax bracket, so that you pay different percentages on each level of earnings. Your first $8,700 would only be taxed at a 10 percent rate in 2012.
Your Effective Tax Rate
Your effective tax rate is the average of all the marginal tax rates you paid on various earnings levels. For example, if you pay $21,000 in taxes on $100,000 in taxable income in 2012, your effective tax rate is 21 percent. During that year, you would have paid graduated rates from 10 percent to 28 percent on four tiers of your income, but this would average out to an effective tax rate of 21 percent. Note, however, that your top rate is 28 percent.
What Your Deductions Are Worth
To figure out what your tax deductions are actually worth, you typically multiply the deductions by your tax bracket. Suppose you're in the middle of the 28 percent tax bracket. A $100 tax deduction will save you $28. If you're near the low end of the tax bracket, however if may get more tricky. Suppose you earn enough to be in the 28 percent bracket, but only by $300. To calculate how much a $1,000 deduction would save you, you would multiply $300 by 28 percent, and the remaining $700 by 25 percent, the rate at which that money would otherwise be taxed.
Do not confuse tax deductions with tax credits. Tax credits come directly off your tax bill. If you owed $21,000 in taxes and took a tax credit of $1,000, you would only owe $20,000 in taxes. The IRS offers a number of tax credits, from child tax credits to business tax credits.
- tax forms image by Chad McDermott from Fotolia.com