D. Adding It All Up: The Value of Tax Deductions

Most taxpayers, even sophisticated businesspeople, don't fully appreciate just how much money they can save with tax deductions. Of course, only part of any deduction will end up back in your pocket as money saved. Because a deduction represents income on which you don't have to pay tax, the value of any deduction is the amount of tax you would have had to pay on that income had you not deducted it. So a deduction of $1,000 won't save you $1,000 -- it will save you whatever you would otherwise have had to pay as tax on that $1,000 of income.

Federal and State Income Taxes

To determine how much income tax a deduction will save you, you must first figure out your income tax bracket. The United States has a progressive income tax system for individual taxpayers with six different tax rates (called tax brackets), ranging from 10% of taxable income to 35% (see the chart below). The higher your income, the higher your tax rate.

You move from one bracket to the next only when your taxable income exceeds the bracket amount. For example, if you are a single taxpayer, you pay 10% income tax on all your taxable income up to $7,825. If your taxable income exceeds $7,825, the next tax rate (15%) applies to all your income over $7,825 -- but the 10% rate still applies to the first $7,825. If your income exceeds the 15% bracket amount, the next tax rate (25%) applies to the excess amount, and so on until the top bracket of 35% is reached.

The tax bracket in which the last dollar you earn for the year falls is called your marginal tax bracket. For example, if you have $60,000 in taxable income, your marginal tax bracket is 25%. To determine how much federal income tax a deduction will save you, multiply the amount of the deduction by your marginal tax bracket. For example, if your marginal tax bracket is 25%, you will save 25¢ in federal income taxes for every dollar you are able to claim as a deductible business expense (25% x $1 = 25¢).

This calculation is only approximate, because an additional deduction may move you from one tax bracket to another and thus lower your marginal tax rate. For example, if you're married filing jointly and your taxable income is $129,000, an additional $1,000 deduction will lower your marginal tax rate from 28% to 25%. The first $500 of the deduction will save you $140 in tax (28% x $500 = $140); the remaining $500 will save you $125 (25% x $500 = $125). So your total tax saving is $265, instead of the $280 you would get if, say, your taxable income was $130,000.

The following table lists the 2007 federal income tax brackets for single and married individual taxpayers and shows the federal income tax savings for each dollar of deductions.

Income tax brackets are adjusted each year for inflation. For current brackets, see IRS Publication 505, Tax Withholding and Estimated Tax.

[2007 Federal Personal Income Tax Brackets chart] omitted for online sample chapter.

You can also deduct your business expenses from any state income tax you must pay. The average state income tax rate is about 6%, although seven states (Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming) don't have an income tax. You can find your state's tax rates at www.taxadmin.org/fta/rate/ind_inc.

Self-Employment Taxes

Everyone who works -- business owner and employee alike -- is required to pay Social Security and Medicare taxes. Employees pay one-half of these taxes through payroll deductions; the employer must pony up the other half and send the entire payment to the IRS. Business owners must pay all of these taxes themselves. Business owners' Social Security and Medicare contributions are called self-employment taxes.

Self-employment taxes consist of a 12.4% Social Security tax on self-employment income up to an annual limit; in 2007, the limit was $97,500. Medicare taxes are levied on all self-employment income at a 2.9% rate. This combines to a total 15.3% tax on self-employment income up to the Social Security tax ceiling. However, the effective self-employment tax rate is lower because (1) you are allowed to deduct half of your self-employment taxes from your net income for income tax purposes and (2) you pay self-employment tax on only 92.35% of your net self-employment income. The following chart shows the effective self-employment tax rates.

[Self-employment tax chart] omitted for online sample chapter.

Like income taxes, self-employment taxes are paid on the net profit you earn from a business. Thus, deductible business expenses reduce the amount of self-employment tax you have to pay by lowering your net profit. This makes business tax deductions doubly valuable.

Total Tax Savings

When you add up your savings in federal, state, and self-employment taxes, you can see the true value of a business tax deduction. For example, if you're in the 25% federal income tax bracket, a business deduction can be worth as much as 25% (in federal taxes) + 12.3% (in self-employment taxes) + 6% (in state taxes). That adds up to a whopping 44.3% savings. (If you itemize your personal deductions, your actual tax savings from a business deduction is a bit less because it reduces your state income tax and therefore reduces the federal income tax savings from this itemized deduction.) If you buy a $1,000 computer for your business and you deduct the expense, you save about $433 in taxes. In effect, the government is paying for almost half of your business expenses. This is why it's so important to know all of the business deductions to which you are entitled -- and to take advantage of every one.

Don't buy things just to get a tax deduction. Although tax deductions can be worth a lot, it doesn't make sense to buy something you don't need just to get a deduction. After all, you still have to pay for the item, and the tax deduction you get in return will only cover a portion of the cost. If you buy a $1,000 computer, you'll probably be able to deduct less than half the cost. That means you're still out over $500 -- money you've spent for something you don't need. On the other hand, if you really do need a computer, the deduction you're entitled to is like found money -- and it may help you buy a better computer than you could otherwise afford.

[The Value of Common Tax Deductions chart] omitted for online sample chapter.

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