After they calculate their deductions and exemptions, taxpayers subtract that amount from their gross income. The sum is their taxable income. Deductions reduce taxable income; credits reduce tax. There are four principal types of deductions:
- Business deductions: These are claimed as part of a business’s income tax.
- Adjustments: These are deductions a taxpayer may claim even if the taxpayer does not claim itemized deductions. Adjustments include alimony and contributions to IRAs or Keogh plans. After subtracting these adjustments from total income, taxpayers arrive at their adjusted gross income.
- Itemized or standard deduction: Taxpayers may claim a list of specifically itemized deductions, or taxpayers may take the standard deduction, whichever is larger. There are quite a few things one can add to the list of itemized deductions, including medical expenses, state and local taxes, mortgage interest, and investment expenses. If taxpayers’ itemized deductions do not have a large enough total, the taxpayers may claim the standard deduction instead. The standard deduction depends on filing status; it is adjusted each year for inflation.
- Exemptions: Taxpayers get a personal exemption in addition to an exemption for each person who qualifies as the taxpayer’s dependent. Like the standard deduction, the exemption deduction is adjusted each year for inflation.
Individuals arrive at taxable income after they subtract these four categories of deductions from their total income.