How Deductions Affect Taxes

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Savings is the mother of wealth creation.
Savings is the mother of wealth creation. (Image: Hemera Technologies/Photos.com/Getty Images)

Treating an expenditure as a deduction doesn't eliminate its cost, not even if it's seemingly justified by using terms such as "I'll just write it off" or "I'll charge it to the business.” Gaining an understanding of how expenditures can become legitimate business or personal deductions and affect taxes will make us better shoppers and better businessmen.

The Road to Financial Success

When Benjamin Franklin, author, inventor, statesman and American founding father wrote, "a penny saved is twopence dear," he was probably alluding to a basic principal of wealth creation. Amassed wealth comes from the reinvestment of profit; profit arises from risk investment and, most important, investment starts with savings. That "penny saved" represents the crucial first step toward personal financial independence and entrepreneurial success. Understanding how deductions affect taxes leads to much broader issues of business profit maximization and individual financial responsibility.

Deductions from Income

Eligible personal and business expenses reduce taxable income, which in turn lowers the tax payable on the remaining income or earnings. For example, you paid real estate taxes for the year of $3,000 and you're in a 25 percent tax bracket. If your income before a deduction for real estate taxes was $100,000, you would have a tax bill of $25,000. Applying the real estate deduction reduces taxable income to $97,000 and your tax liability shrinks to $24,250. Because that $3,000 deductible expense saved you $750 of taxes, your real estate taxes really only cost $2,250.

Deductions on Steroids (Tax Credits)

Sometimes instead of a deduction, personal expenses qualify for a government subsidy called a tax credit. Examples are the tax credits granted to first time home buyers in recent years or the currently available federal Child Tax Credit and Earned Income Credit. Using the above example, $3,000 in child care costs for a family with joint income of $100,000 could be applied directly against the $25,000 tax bill instead of just lowering taxable income. That means 100 percent of child care expenses were offset by the $3,000 reduction in income tax. In this case, a tax credit was four times more powerful than an expense deduction.

The True Cost of Deductions

The impact of spending can sometimes be lessened by claiming the expense as a deduction that reduces taxable income. Still, the net cost of that purchase should be weighed against the benefit of growing personal savings or increasing business retained earnings gained by not spending the money in the first place. Forbearance is a common characteristic of many successful people, who value the lasting power of savings over the temporary benefit of non-essential spending, which robs families and businesses alike of the opportunity to grow wealth.

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