There’s no doubt you’ve heard the term ‘tax deduction’, but do you actually know how tax deductions affect your taxes?
Does a tax deduction reduce taxable income?
Now, I know that your eyes are already glazing over and your thoughts are starting to drift, but stay with me here. I’m going to make it quick and painless, but be sure to add another feather in your cap – the almighty feather of understanding of the most commonly used tax term – tax deduction.
This article is a basic overview of tax deductions, how they work and why they are a good thing. After reading this short post, you will have a legendary understanding of how tax deductions are applied and, because of this new-found knowledge, there’s no doubt you’ll be a huge conversation hit at your next dinner party.
What is a Tax Deduction?
In its simplest form, a tax deduction is an expense incurred in the act of producing assessable income for tax purposes.
Now, while the definition and provisions aren’t as wide as the definition above, it does give you the reasoning behind a tax deduction.
Basically, the Government is saying, if you pay for something that is required to help you produce income that will then be taxed; then you can have a tax deduction for that expense.
The expectation is that, not only will you be spending money in the economy (essentially causing other people to pay taxes too), but you will hopefully be increasing the amount you earn through your purchases and will therefore pay more tax.
Take for example a tradesperson buying newer tools so they can work more efficiently, completing more jobs and earning more income. There is a benefit to the tradesperson (higher profits), benefit to the person the tools were bought from (another sale), benefit to the ATO (collecting income tax from the tradesperson and the tool shop owner) and, ultimately, a benefit to the Australian public, because those taxes are used to pay for roads, schools, hospitals, social services and to look after our parents and grandparents.
In Australia, personal income tax accounts for more than 40% of total tax revenue collected by the Government.
Interestingly, the chart below shows Australia’s sources of tax revenue as a percentage (blue bars) and compares that to the average of OECD countries (grey box). Click here to see a list of OECD countries.
How Do Deductions Affect Your Taxes?
For most of us, the income we earn is assessable income, which means it falls in the net that the Australian Tax Office (ATO) assesses for tax.
But, despite all of your income being ‘assessable‘, it does not make it all ‘taxable‘.
Your taxable income is your assessable income, minus any tax deductions.
Taxable Income = Assessable Income – Tax Deductions
Let’s take a peak at a simple example of how a tax deduction works:
If I earn $80,000 income each year and have $10,000 worth of tax deductions (expenses relating to me earning such income), then my taxable income would be $70,000.
How Much Tax Do I Pay on $70,000?
Here is the individual marginal tax rates in Australia. These tax rates are amended each year, usually as a result of the Federal Budget.
The current tax rates are as follows for Australian Residents for the 2016/2017 financial year:
Taxable Income,Tax On This Income
$18 201 – $37 000,19c for each $1 over $18 200
$37 001 – $87 000,$3 572 plus 32.5c for each $1 over $37 000
$87 001 – $180 000,$19 822 plus 37c for each $1 over $87 000
Over $180 000,$54 232 plus 45c for each $1 over $180 000
Up-to-date individual marginal tax rates should be able to be found here.
There is the Medicare Levy and Budget Repair Levy that are payable in addition to the above and numerous tax offsets that can reduce taxable income, but we want to keep this simple.
So, on my $70,000 taxable income after my $10,000 tax deductions, as we talked about earlier, the income tax that I would pay would be $14,297, calculated as:
(($70,000 – $37,000) x 0.325) + $3,572
You would type it into your calculator in the same order as it is listed in the formula above.
Do Tax Credits Reduce Taxable Income?
Tax credits don’t reduce taxable income. Instead tax credits or offsets or rebates (which all have similar application) will reduce the tax payable. So, based on my tax payable of $14,297, above, if I had a $2,000 tax credit, I would only need to pay $12,297.
Regular PAYG or PAYE payments made throughout the year are considered tax credits, as they are ‘tax already paid’, but there are numerous other forms of tax credits, offsets and rebates.
How to Reduce Income Tax in Australia
There are plenty of legitimate tax minimisation strategies to reduce taxable income in Australia.
If you are wanting to pay less tax, just make sure it is done legally and above-board, because there are hundreds of dodgy schemes out there and the ATO isn’t stupid.
Hopefully this article has helped your understanding of tax deductions and how they affect your taxes. I was tempted to include more comprehensive information including specific tax minimisation strategies and how to pay less tax, legally; however explaining how tax deductions work is probably enough tax talk for one day. I’ll save those tips for another post.