Taxpayers frequently ask what benefit is derived from a tax deduction. Unfortunately, there is no straightforward answer. The reason the benefit cannot be determined simply is because some deductions directly reduce gross income, while others must be itemized, must exceed a threshold amount before being deductible, or are not deductible for alternative minimum tax purposes. Meanwhile, business deductions can offset both income and self-employment tax. In other words, there are many factors to consider, and the tax benefits differ for each individual, depending on his or her particular situation.
For most non-business deductions, the savings are based upon your tax bracket. For example, if you are in the 25% tax bracket, a $1,000 deduction would save you $250 in taxes. However, if taxable income approaches the next lower tax bracket, the benefit will be less. You also need to consider whether the particular deduction is allowed on your state return and what your state tax bracket is in order to determine the total tax saving.
Some deductions, such as IRA and self-employed retirement plan contributions, alimony, student loan interest, moving expenses, and so forth, are adjustments to income, or what we call above-the-line deductions. These deductions provide a dollar-for-dollar benefit. Deductions that fall into the itemized category must exceed the standard deduction for your filing status before any benefit is derived. In addition, medical deductions are reduced by 7.5% (to be adjusted to 10% in 2013 except for seniors) of your AGI (income), and the miscellaneous deductions are reduced by 2% of your AGI. For taxpayers subject to the alternative minimum tax, the medical adjustment goes to 10%, while deductions for taxes, home equity interest, and miscellaneous deductions above the 2%-of-AGI floor are not allowed at all.
Business deductions, the most beneficial deductions, fall into two categories: employee business expenses, which are treated as miscellaneous itemized deductions subject to the limitations described previously, and self-employed business expenses that offset both income tax and, depending upon the circumstances, self-employment tax. For 2012, the self-employment tax rate is 10.4% of the first $110,100 of income subject to SE tax plus 2.9% for the Medicare tax with no cap. For self-employed businesses with a net income (profit) of $110,100 or less, the effective SE tax rate is 13.3%, and the benefit derived from deductions generally includes the taxpayer’s tax bracket plus 13.3%. For example, for a taxpayer in the 25% tax bracket, the benefit could amount to as much as 38.3% (25% + 13.3%) of the deduction. If the deduction were $2,000, tax savings could be as much as $766 or more when the taxpayer’s state income tax bracket is included.