Tax deductions introduction
About this video
Sal clears up a common misconception: a tax deduction is not subtracted from the taxes you owe, it is subtracted from your reported income. Using a $10,000 mortgage interest deduction for someone earning $100,000, he shows the real tax saving is the deduction times the marginal rate (28%), or $2,800.
You'll be able to
- explain that a tax deduction lowers reported (taxable) income, not the tax bill directly.
- calculate the tax saved by a deduction using the marginal tax rate.
- tell the difference between a tax deduction and a tax credit.
Key words
- Tax deduction
- An amount you subtract from your reported income before your tax is calculated.
- Mortgage interest
- The part of a home loan payment that is interest; in this example it is tax deductible.
- Reported income
- The income you state on your tax return; a deduction makes this number smaller.
- Tax credit
- An amount subtracted directly from the taxes you owe.
- Marginal tax rate
- The tax rate you pay on your last (top) dollars of income, here 28%.
Transcript
In this video, I now want to cover one of the other most misunderstood ideas when people think about taxes, and that's the idea of deductions. So, one of the most common tax deductions is the deduction you get on interest on your mortgage. So let's say that this year on my mortgage-- of the part of my mortgage that is interest, let's say it's $10,000.
It is $10,000 on my interest on my mortgage. And you'll either already know or someone might tell you that this is tax deductible. And the misconception that I've seen many, many times is that people think that since this is a tax deduction, that this $10,000 should be deducted from their taxes.
So in the previous example, we showed the scenario where this person making $100,000 would have to pay $21,720 in taxes. And so based on that misconception, they would say, OK, I get a $10,000 tax deduction, now I would pay $11,720. And that is wrong. The deduction doesn't happen from the taxes you pay.
The deduction happens from your stated income. So if this person right here had a $10,000 tax deduction, instead of saying that they made $100,000 that year, they would say that they made $90,000. So once again, the deduction does not come directly from the taxes.
That would be a tax credit. The deduction comes from the reported income. So what would be the actual effect on the taxes? Well, we just have to look at this $90,000. It still kind of shows up in that top bracket. So the real difference is just going to be this $10,000 difference.
Before, he was paying 28% on this $10,000. Now he won't have to pay 28% on that incremental $10,000. Another way to think about it, instead of this being 17,750 times 28%, it would now be 7,750. Because the reported income is now only $90,000. So the actual number-- we can get our calculator out and just calculate it.
There's two ways you could do it. You could just say, look, if I'm going to have spent 10,000-- if my income is deducted by 10,000, and I'm going to save 28% on that 10,000, you could just subtract 2,800 from this. But just to show you how it'll all work, that it all works out to the same thing, let's just go through the same calculation again.
We have 7,750 times 0.28 plus 48,300 times 0.25 plus 25,600 times 0.15 plus $835. And it's $18,920. So now the taxes will be $18,920. And as you can see, the difference between the old and the new is exactly $2,800 because that's essentially what the amount that we would be taxed on that $10,000 if we had made that much money.
Anyway, hopefully that doesn't confuse you too much.
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