What is Tax deduction?

A tax deduction lowers your taxable income, which reduces the amount of tax you owe. The value depends on your tax bracket. Deductions work by lowering the income figure that is applied to tax brackets. The value of a tax deduction is directly tied to the taxpayer's marginal tax rate: for example, a $1,000 deduction saves a taxpayer in the 22% tax bracket $220 in taxes, whereas it saves a taxpayer in the 32% bracket $320.

There are two main types of tax deductions: above-the-line deductions and below-the-line deductions. Above-the-line deductions (adjustments to income) are subtracted from gross income to determine Adjusted Gross Income (AGI). These include HSA contributions, student loan interest, and traditional IRA contributions. Below-the-line deductions are subtracted from AGI and include either the standard deduction or itemized deductions.

Maximizing tax deductions is a core tax reduction strategy. Unlike tax credits, which reduce tax liability directly dollar-for-dollar, deductions reduce the base of taxable income.