The reason that so much emphasis is put on deductions is that, when you can add additional deductions to your taxes, it reduces the amount of income that you have that's taxed at the highest rate. A bit of explanation of tax brackets is in order here.
Remember Tammy? She's a single person, so her tax brackets look like this in 2021:
- 10%: Up to $9,875
- 12%: $9,876 to $40,125
- 22%: $40,126 to $85,525
What this means is that her first $9,875 in taxable income is taxed at a 10% rate, then all income from $9,876 to $40,125 is taxed at a 12% rate, then the rest of her income up to the $50,000 she earned is taxed at the 22% rate.
So, if she were paying taxes on the full $50,000, she would owe:
- 10% of $9,875, plus
- 12% of $30,250 (which is $40,125 minus $9,875), plus
- 22% of $9,875 (which is $50,000 minus $40,125)
That adds up to $6,790 in taxes.
Remember, most Americans don't directly face this bill each year. Instead, money is taken out of each paycheck to cover this. When you file your taxes, you're simply reporting your income and making sure that the money taken out of your check covers that amount.
Now, let's see how deductions change that story for Tammy. After deductions, she's only paying taxes on $35,000. She would owe:
- 10% of $9,875, plus
- 12% of $25,125 (which is $35,000 minus $9,875)
That adds up to only $4,002.50 in taxes.
Those $15,000 in deductions reduced her taxes by $2,787.50, keeping that money right in her pocket.
For most people, these kinds of deductions result in a tax refund check during tax season. That's because the amount taken out of their checks usually assumes that they're paying taxes with limited deductions, so there's plenty taken out of their paycheck. If you're able to deduct many things, then you will have overpaid your taxes by quite a bit, resulting in a big and potentially life-changing tax refund check.
In Tammy's situation, every single additional charitable donation would make her taxable income lower. It would reduce that amount taxed at 12% in the above example, so if she donated $100, she'd see a $12 lower income tax bill, meaning her donation really only cost her $88.
In other words, charitable donations when you already have many deductions reduce your taxes by a little (or by a lot, if you're in a high tax bracket).