An Introduction to Tax Deductions and Retirement Planning

How Tax Deductions Work to Lower the Income Tax You Owe

Tax deductions
A form for tax deductions. emmgunn/Getty Images

A tax deduction is essentially a reduction in income that is subject to state and federal income taxes. By decreasing your total taxable income, tax deductions can reduce the amount of income tax you would have otherwise owed. Tax deductions are most commonly a result of some business expense, but they are also one way that the government incentivizes people to participate in activities that have greater societal benefit like making charitable donations, opting for more environmentally friendly purchases, and even savings for retirement.

What Does It Mean If Something Is a Tax Deduction?

If something is a tax deduction (or is tax-deductible), it may reduce your income tax bill by reducing your taxable income (also known as your adjusted gross income or AGI). Many people consider tax deductions as a tool only used by the rich and famous, but they are mistaken. In fact, there are plenty of tax deductions available for middle- and lower-income families. Some common tax deductible items are things like some health insurance premiums, charitable gifts and donations, and repaid mortgage or student loan interest. Whether or not a tax-deductible expense ultimately reduces the income tax you owe depends on several factors. The biggest differentiator in tax deductions is whether a taxpayer decides to take the standard deduction or to itemize their deductions.

For retirement planning purposes, however, if an item is tax deductible and you have taxable income, you will likely save on your income taxes.

There are no retirement planning deductions that are considered itemized deductions.

What is the Difference Between a Tax Deduction and a Tax Credit?

Both tax deductions and tax credits can lower your income tax bill, but they do so in different ways. As stated above, tax deductions can lower your income tax bill by lowering the amount income that is subject to taxes.

As such, the reduction in taxes owed is equivalent to the total amount you have in tax deductions times your marginal tax rate. A tax credit, on the other hand, directly reduces the income taxes you owe dollar-for-dollar. As such, tax credits are much more valuable, but also much less common.

Income tax credits reduce your federal income tax after your tax has already been calculated, which makes them a powerful tool for bringing down your tax bill. Check out this page for more information on income tax credits.

But that is not to say that tax deductions aren't valuable. If used wisely, they can not only save you money on your total tax bill, but they can also help you fund your retirement.

What are Examples of Retirement Planning-Related Tax Deductions?

The most common retirement planning tax deduction is for traditional IRA contributions. If you meet certain income limits, your contribution to a traditional IRA is tax deductible and, therefore, saves you money on your taxes. You can claim this deduction on your tax return.

How can Health Savings Account contributions lower your taxable income? 

Health savings accounts (HSA) are tax-deductible savings plans that enable a person to save pre-tax dollars for future healthcare expenses.

 An additional benefit of the tax deduction for HSA contributions is that you do not have to itemize deductions to claim the deduction.  For tax purposes, HSA contributions are considered an above the line deduction. This means they can help lower your adjusted gross income (AGI) and potentially help qualify you for other tax deductions and credits that are income dependent. HSAs provide an excellent way to save for retirement because there are no penalties for using these accounts for non-medical expenses once you reach age 65. HSA withdrawals will be tax-free as long as the funds are used to pay for qualified medical expenses.

Are Contributions to a 401(k) Plan Tax Deductible?

In addition to getting a tax deduction for contributing to a traditional IRA, contributions to employer-sponsored retirement plans like 401(k) plans are also tax-deductible.

Unlike an IRA contribution, however, since your 401(k) contributions are automatically deducted from your paycheck before tax withholdings are calculated, you receive the tax savings up front. Since those contributions are subtracted from your taxable wages reported to you and the IRS on Form W2, you can’t deduct your 401(k) contributions again on your tax return.