Tax Deductions for Individuals

Why This Matters

Tax deductions are one of the most powerful tools for reducing your tax liability, and understanding how they work is essential for personal financial literacy. You're being tested on more than just knowing what deductions exist—you need to understand the strategic decision-making behind choosing standard vs. itemized deductions, how income thresholds and caps affect eligibility, and why the tax code incentivizes certain behaviors like homeownership, charitable giving, and retirement savings.

The key concepts here include above-the-line vs. below-the-line deductions, adjusted gross income (AGI) calculations, and the trade-offs between simplicity and optimization. Don't just memorize the dollar amounts—know what category each deduction falls into, who benefits most from each one, and how deductions interact with your overall tax strategy.

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The Standard vs. Itemized Decision

Every taxpayer faces a fundamental choice: take the standard deduction or itemize specific expenses. This decision point is central to tax planning and appears frequently on exams.

Standard Deduction

• Fixed dollar amount that reduces taxable income—varies by filing status (single, married filing jointly, head of household)
• No documentation required—simplifies filing for taxpayers whose itemized deductions wouldn't exceed this threshold
• Adjusted annually for inflation—making it increasingly attractive as the amounts rise, which is why fewer taxpayers now itemize

Itemized Deductions

• Allows listing specific qualifying expenses—requires Schedule A and documentation for each claimed expense
• Strategic choice when total exceeds standard deduction—taxpayers in high-tax states or with large mortgages often benefit
• Subject to various caps and limitations—including the $10,000$ SALT cap and AGI-based thresholds for medical expenses

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Homeownership Incentives

The tax code deliberately encourages homeownership through deductions that reduce the effective cost of buying and maintaining a home. These represent below-the-line deductions available only to itemizers.

Mortgage Interest Deduction

• Deduct interest on loans up to $750,000$—applies to primary residence and, in some cases, a second home
• Only the interest portion qualifies—principal payments do not reduce taxable income
• Largest itemized deduction for most homeowners—often the deciding factor in whether to itemize

State and Local Tax (SALT) Deduction

• Deduct state/local income OR sales taxes, plus property taxes—taxpayers choose income or sales, whichever is higher
• Capped at $10,000$ total—significant limitation for taxpayers in high-tax states like California, New York, and New Jersey
• Disproportionately affects high-income earners in high-tax states—a frequent topic in discussions of tax policy fairness

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Incentivizing Positive Behaviors

The tax code uses deductions to encourage socially beneficial activities like charitable giving, saving for retirement, and investing in education. These represent policy tools embedded in tax law.

Charitable Contributions Deduction

• Deduct donations to qualified 501(c)(3) organizations—includes cash, property, and appreciated assets
• Cash donations limited to 60% of AGI—with lower limits for property and appreciated stock donations
• Documentation requirements increase with amount—receipts required for donations over $250$, appraisals for property over $5,000$

Retirement Account Contributions

• Traditional IRA and 401(k) contributions reduce taxable income—creating immediate tax savings while building retirement wealth
• Annual limits apply—$23,000$ for 401(k) in 2024, $7,000$ for IRAs, with catch-up contributions for those 50+
• Income phase-outs may limit IRA deductibility—especially for those covered by workplace retirement plans

Student Loan Interest Deduction

• Deduct up to $2,500$ of interest paid annually—an above-the-line deduction available even without itemizing
• Phases out at higher income levels—begins reducing at $75,000$ (single) or $155,000$ (married filing jointly)
• Benefits recent graduates most—when loan balances and interest payments are highest relative to income

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Medical and Healthcare Costs

Medical deductions recognize that significant healthcare costs reduce a taxpayer's ability to pay taxes. However, the threshold makes this deduction useful only for those with substantial expenses.

Medical Expenses Deduction

• Only expenses exceeding 7.5% of AGI qualify—meaning someone with $100,000$ AGI must have over $7,500$ in expenses before any deduction
• Eligible costs include hospital bills, prescriptions, and long-term care—but not cosmetic procedures or general health items
• Requires itemizing and meticulous documentation—receipts, insurance statements, and records of all qualifying expenses

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Self-Employment and Professional Deductions

Self-employed individuals and certain professionals have access to unique deductions that reflect the costs of earning their income. These are typically above-the-line deductions that reduce AGI directly.

Self-Employment Expenses

• Deduct ordinary and necessary business expenses—including home office, supplies, equipment, travel, and professional services
• Home office deduction requires exclusive business use—can use simplified method ($5$ per square foot, up to 300 sq ft) or actual expenses
• Self-employment tax deduction—can deduct 50% of self-employment taxes paid, recognizing the employer-equivalent portion

Educator Expenses Deduction

• Teachers can deduct up to $300$ of unreimbursed classroom expenses—an above-the-line deduction available without itemizing
• Applies to K-12 educators working 900+ hours annually—includes teachers, counselors, principals, and aides
• Covers books, supplies, equipment, and professional development—but not home schooling expenses

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Quick Reference Table

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Self-Check Questions

1. Which deductions can you claim even if you take the standard deduction instead of itemizing? Name at least three.

2. A taxpayer has $80,000$ AGI and $8,000$ in medical expenses. How much can they deduct, and why does the 7.5% threshold matter?

3. Compare and contrast the SALT deduction and the mortgage interest deduction—what do they have in common, and how do their limitations differ?

4. Why might a high-income earner in a low-tax state choose the standard deduction, while someone with similar income in New York might itemize?

5. If an FRQ asks you to explain how the tax code encourages retirement savings, which deductions would you discuss and what makes them effective policy tools?