What is a 'Deduction'
A deduction is any item or expenditure subtracted from gross income to reduce the amount of income subject to income tax. It is also referred to as an "allowable deduction." For example, if you earn $40,000 and claim a deduction for $1,000, then your taxable income is reduced to $39,000.
BREAKING DOWN 'Deduction'
As of 2016, the IRS offers taxpayers a standard deduction of $6,300 for single filers and $12,600 for filers who are married filing jointly. The standard deduction for head of household filers is $9,300. Tax filers do not have to pay income tax on earnings lower than these thresholds. To illustrate, if you earn $6,400 and claim the standard deduction of $6,300, you only have $100 of taxable income.
Tax filers may also opt to itemize their deductions. This means the tax filer adds up a list of allowable deductions. Then, he claims the total as a deduction rather than using the standard deduction on his income tax return. Popular itemized deductions include interest on mortgage loans, contributions to retirement accounts, property taxes and many others.
If you opt to claim the standard deduction, there are still some itemized deductions you can claim on your income tax return. These include eligible student loan interest and moving expenses.
Deductions vs. Business Expenses
Business expenses are expenses incurred in the pursuit of earning a profit for your business. When you report business income to the IRS, you report all of your income, but then you deduct your business expenses from that amount. The difference is your net income.
When you report your net business income as earnings on your income tax return, you are then allowed to subtract standard or itemized deductions from that amount. Business expenses work like deductions in that they are deducted from your wages. However, they are not exactly the same as deductions.
Deductions vs. Credits
Credits are relatively analogous to deductions. They help lower the amount of tax a tax filer must pay, but they work in a different way than deductions. A credit is subtracted from the amount of tax you owe, not from your reported income. The IRS has both refundable and nonrefundable credits. Nonrefundable credits cannot trigger a tax refund, but refundable credits can.
For example, imagine that after reporting your income and claiming your deductions, you owe $500 in income tax. However, you are eligible for a $600 credit. If the credit is nonrefundable, your tax bill is erased, but you do not receive any extra money. If the credit is refundable, you receive a $100 tax refund.