For individuals and married parties filing taxes, it is important to understand the basic income tax formula:
[(Income – Deductions) x Tax Rate] – Credits & Payments = Taxes Owed/Tax Refund
Clearly from this formula, taxpayers with more income or higher tax rates will ultimately owe more taxes barring other considerations.
To understand how the Standard Deduction works, we are going to use an example throughout this article:
In 2022, Thelma was a single mother, living with her five year old daughter for the entire year. The child did not spend time with her father, allowing Thelma to claim the Head of Household tax filing status.
Finding Adjusted Gross Income
The first step in the taxation process is to report to the IRS all of the taxpayer’s net income for the tax period, including everything from wages and self-employment income to gambling proceeds, rental income, and gains from cancelled debt. Some of the more common streams of income go directly onto the 1040, but more complex sources (e.g., sole proprietors, freelance work) will use a variety of schedules (e.g., Schedule 1 and Schedule C) as worksheets to input revenue and expenses in order to find the right total for the Form 1040.
Once the income has been totaled, this is written down on the Form 1040 as Total Income (see Line 9 above).
Thelma works as an employee for ABC company and earned approximately $40,000 in 2022 from her job. She has no other source of income. Her Total Income is $40,000.
The taxpayer is then allowed some adjustments (see Schedule 1 again) that most taxpayers are allowed to use to decrease their income. As discussed in our prior article about tax brackets, taxes are based on a rate (e.g., 10%) multiplied by your income (Income x 10%). The lower you can get your income, the less you will have to pay in taxes.
Once those adjustments are made, the final income is written down on the Form 1040 as Adjusted Gross Income or AGI (see line 11 in the 1040 above, Figure 1). Those of you who have applied for Student Aid or various loans may be very familiar with this figure as many lenders base their offering on AGI.
Thelma still pays her student loan bills each month and was able to contribute $2,000 towards interest on those loans. She uses this as an adjustment to her income. $40,000 (Total Income) – $2,000 (Adjustment) = $38,000 (AGI).
How the Deduction Works
Once AGI is determined, there is one more way to decrease your income before the tax rate is applied – through either the Standard Deduction or the Itemized Deductions. The concept is rather more complex, but ultimately the government has decided that it wants to leave families enough money to cover important bills or losses (e.g., medical bills) or to contribute to the social good (e.g., charity).
In theory, the government has a list of potential expenses that they are willing to let you ‘remove’ (deduct) from your AGI before the apply the tax rate. The full list of deductions is usually available on the Schedule A. Unfortunately, the options are limited and many taxpayers in the mid- to lower- tax brackets will never actually have many of the expenses.
The main categories of allowed expenses include:
- Medical & Dental Expenses
- Taxes Paid to the State or Federal Governments
- Some Types of Interest Paid on Mortgages or Investments
- Charitable Gifts
- Casualty & Theft Losses
It is important to note that there may be significant limitations on the amount or types of expenses that qualify under these categories. For example, medical and dental expenses are generally limited to the amount that is more than 7.5% of your income. So if your income is $100,000.00 for 2022, you would not be able to include the first $7,500.00 in medical expenses.
The taxpayer needs to save documentation of these receipts and total the allowed expenses at the end of the year to see how much they would be able to claim.
Thelma has calculated her Schedule A expenses and realizes that she could claim $11,500 due to a significant casualty loss when her home was robbed and insurance did not help cover the loss.
The Standard Deduction
To ensure equity for all taxpayers, the government has created what is known as the Standard Deduction. This is an amount that any taxpayer can apply to their income, regardless of how much they spent on that list of Schedule A expenses. The amount allowed will depend on the taxpayer(s) marital status and often adjusts upward for inflation.
Thelma’s applicable expenses were $11,500, much lower than the standard deduction for a Head of Household is allowed. She is able to claim the full deduction ($19,400.00) on her tax form. This number would subtract from her AGI. $38,000 (AGI) – $19,400 (Standard Deduction) = $18,600 (Taxable Income).
Figure 4 shows the 2021 Form 1040, where Thelma would have written $38,000 on line 11, $19,400 on line 12, and then calculated the total on line 15. Taxable Income is an important figure — this is the amount that is multiplied against the tax rate to find the initial taxes owed.
(Taxable Income * Tax Rate) = Initial Taxes Due
Notice that without the Standard Deduction, Thelma would have a taxable income of $38,000. She now had lowered that by more than 50%, dropping her taxes at the same time.
Special Circumstances for the Standard Deduction
Have you noticed that at the top of the Form 1040, there is a section titled Standard Deduction that asks you certain questions about your physical age, dependency, and disabilities?
This is because your Standard Deduction can be increased or decreased based on these factors. Typically, if you are either blind or 65+ in age, your standard deduction increases. Whereas, if you are a dependent, your standard deduction may decrease.
Married & Qualifying Widowers
Single & Head of Household
In 2022, a dependent of another taxpayer would only be able to claim a standard deduction of $1,150 or their earned income plus $400 (whichever was greater). This increased to $1,250 for 2023. It is of course limited to the regular standard deduction as a maximum.
Thelma is also legally blind with doctor’s diagnoses to support her claim. She will claim her usual $19,400 but also an additional $1,750 as Head of Household. Her new Taxable Income is $38,000 (AGI) – $21,150 (Standard Deduction) = $16,850.
Thelma’s daughter is also filing taxes as a single taxpayer because she worked at Walmart last year as a clerk. She earned $9,000 at her job and has no adjustments; so her AGI and earned income were $9,000. Her Standard Deduction is limited to the larger of $1,150 or ($9,000 + $400). She claims $9,400 as her maximum Standard Deduction.
The Itemized Deduction
Some people actually spend more money on those allowed expenses than the government allowed for with the standard deduction. In this case, they are allowed to total their actual expenses as a different itemized deduction.
Taxpayers can use either the Standard or Itemized Deduction; if done properly, they will choose whichever was larger.
Thelma recalculates her expenses and realizes that she forgot some allowed medical expenses. Her new expenses for this deduction are $20,700. This is higher than the standard deduction. So she will fill out the Schedule A and itemize, writing down $20,700 on that line instead.
Standard Deduction or Itemized Deduction?
The Standard Deduction offers a minimum for those taxpayers who have fewer expenses, allowing them to take advantage of this benefit like everyone else. Once a taxpayer begins to have higher expenses, they may want to go above this minimum amount and use their actual expenses. This is the Itemized Deduction.
The taxpayer will choose whichever was larger.