Buzz
Thinking of upgrading your computer? Write it off! Dining at an extravagant French restaurant? Write it off! There’s a common misconception that when it comes to deductible expenses, writing them off means you essentially get them for free. But that’s not exactly the case. So how much do you actually save when you write something off? We consulted some tax experts for their insights.
“This is one of my all-time favorite tax concepts that people often misunderstand,” says Mark Durrenberger, a Certified Financial Planner and author of The Modern Day Millionaire. “I think this confusion was only made worse by the famous Seinfeld scene where Jerry doesn’t understand what ‘writing it off’ means, and that’s fine because some big corporation gets it, and ‘they’re the ones writing it off!’”
We’ve all seen the episode, and it’s not just major corporations that can write things off. Individuals can do it too. (Though many of these deductions are at risk due to this new tax bill.) But writing things off may not mean what you think it does.
Tax Credits vs. Tax Deductions
First, it's important to distinguish between tax credits, such as the Electric Vehicle Credit or the Child Tax Credit (both of which may face cuts in 2024), and expenses that are simply deductible. As the IRS clarifies, tax credits directly reduce your income tax liability on a dollar-for-dollar basis. “This means a $1,000 tax credit lowers your tax bill by $1,000,” they state.
On the other hand, tax deductions work by lowering your taxable income.
Essentially, a tax write-off decreases the amount of taxes you owe by reducing your taxable income by the value of the write-off,” explains Durrenberger. “This saves you whatever your tax rate is, multiplied by the amount of the write-off.”
Deductions lower your taxable income, but the actual tax savings depend on your tax bracket, the specific deduction, and the size of the write-off. Finance website Zacks explains it clearly:
“This means you calculate your gross income for the year and subtract any expenses before determining your tax bill. If you earned $50,000 and deducted a $100 expense, your taxable income would be $49,900.”
In other words, deducting a $100 business expense doesn’t mean you’ll save the full $100. You’ll only save the taxes you would have paid on that $100, as Durrenberger explains. This is why understanding your tax bracket is crucial.
Determine Your Marginal Tax Bracket
If you’re confused already, did you know that you don’t pay a single flat tax rate? Our tax system is tiered, meaning you pay a different percentage depending on each income bracket. Here are the tax brackets for 2017:
For example, if you earned $50,000 in a year, you don’t pay a flat 25% tax rate. Instead, you only pay that rate on income over $37,950. Your first $9,325 would actually be taxed at just 10%.
The highest bracket that applies to your income is called your marginal tax bracket. In our example, your marginal tax bracket would be 25%. This figure is essential for understanding how much your deductions can truly save you.
How to Determine Your Tax Savings
Before diving into how your marginal tax bracket plays a role, let’s clear up some confusion. Not only is a deduction not a straight dollar-for-dollar savings, but you also can’t deduct every expense in full. There are limits! For instance, when it comes to business meals and meals while traveling for business — you can generally only deduct 50% of the cost.
To calculate how much you’ll save with a federal income tax deduction, multiply the deductible amount (after considering any percentage limits) by your marginal tax bracket. “For instance, if your marginal tax bracket is 25%, you’ll save 25¢ in federal income taxes for every dollar you can deduct as a business expense,” Nolo explains. For a $100 deduction, that means a $25 savings. For a $50 business meal write-off, you’d save around $6. ($50/2 x 0.25).
This is a general rule, but it can get more complicated due to those tax brackets. For example, if your deduction is $1,000 but you’ve only just crossed into the 28% bracket by a few hundred dollars (your taxable income is $38,250), the write-off affects more than just your marginal bracket. So, you won’t be able to calculate your savings by simply applying the 28% rate. Zacks describes it this way:
Imagine you earn enough to be in the 28% bracket, but only by $300. To determine how much a $1,000 deduction will save you, you’d multiply $300 by 28%, and the remaining $700 by 25%, the rate at which that portion would otherwise be taxed.
This gives you a clear picture of how much you’ll truly save. However, if you’re only seeking an estimate, you can use one rate for a rough calculation and still come close to the right number. Just don’t expect your write-offs to cover all your expenses on their own.
