How tax deductions actually work

Part of Financial 101 › Tax. General information about US federal tax rules for tax year 2026, not tax advice. State rules differ. Figures come from IRS Revenue Procedure 2025-32 and IRS Notice 2025-67 and change yearly; the IRS is the source of truth. For your own situation, see when you need a CPA.

Start with the misunderstanding

Ask ten people what it means to be “in the 22% bracket” and most will tell you the government takes 22% of their income. It does not. Federal income tax is marginal: income is stacked into layers, and each layer is taxed at its own rate. The first slice of your taxable income is taxed at 10%, the next slice at 12%, the slice after that at 22%, and so on through seven rates ending at 37%. Being in the 22% bracket means only your top slice is taxed at 22%. Everything beneath it is taxed at the lower rates, exactly as it would be for someone who earned less.

Two consequences follow, and both are worth internalising. A raise that pushes you into a higher bracket can never leave you with less money; only the dollars above the line are taxed at the new rate. And your effective rate — total tax divided by total income — is always lower than your marginal rate, often much lower. The marginal rate is the one that matters for decisions (should I contribute another dollar to a 401(k)?). The effective rate is the one that matters for understanding what you actually pay.

How taxable income is built

The return works down from the top. Gross income is everything you earned. Subtract a small set of above-the-line adjustments — traditional IRA and HSA contributions, the deductible half of self-employment tax, student loan interest, a few others — and you have adjusted gross income, or AGI. AGI matters beyond the return itself: a lot of eligibility thresholds, from Roth IRA limits to various credits, key off it or a modified version of it.

From AGI, subtract either the standard deduction or your itemised deductions, whichever is larger. What remains is taxable income, and that is the number the brackets are applied to. Then, from the tax that produces, subtract any credits.

The standard deduction

A flat amount everyone may subtract, no receipts required. For 2026:

Filing status	2026 standard deduction
Single, or married filing separately	$16,100
Head of household	$24,150
Married filing jointly	$32,200

Taxpayers 65 or older, or blind, get an additional amount on top ($2,050 for single filers, $1,650 per qualifying spouse on a joint return). The 2025 tax law also added a separate, temporary deduction for seniors and new deductions for certain tip and overtime income, each with its own eligibility rules and income limits; check the IRS pages if they might apply to you.

Because the standard deduction is large, most households take it. Itemising only makes sense when your deductible expenses add up to more.

Itemising

The main itemised deductions are mortgage interest (within limits), state and local taxes (capped — the 2025 law raised the cap substantially but phases the increase down at higher incomes), charitable gifts, and medical expenses above a percentage-of-AGI floor. If those together exceed your standard deduction, you itemise and deduct the actual total instead.

A tactic worth knowing if you are near the line: bunching. Concentrate two years of charitable giving into one year — a donor-advised fund makes this easy — so you itemise that year and take the standard deduction the next. Same generosity, more deduction.

Deductions versus credits

People use the words interchangeably, and the difference is worth real money. A deduction reduces the income that gets taxed. Its value depends on your marginal rate: a $1,000 deduction is worth $220 to someone in the 22% bracket and $120 to someone in the 12% bracket. A credit reduces the tax itself, dollar for dollar: a $1,000 credit is worth $1,000 to everyone who can use it. Some credits are refundable, meaning they can push your tax below zero and produce a refund; most are not. Credits are strictly better than deductions of the same size, which is why the child tax credit, the education credits, and the Saver’s Credit for retirement contributions deserve a look every year.

What this means for a Boglehead

Almost all of the tax planning an index investor needs comes from three above-the-line or pre-tax moves: the 401(k), the HSA, and the traditional IRA where deductible. Each one removes income from the top of your stack, where it would have been taxed at your marginal rate. That is why a dollar in a traditional 401(k) “costs” a 22%-bracket earner only 78 cents of take-home pay. The Roth works the other way: no deduction now, no tax later, which is the better trade when your marginal rate today is lower than you expect it to be in retirement. Understanding marginal rates is what lets you make that call instead of guessing.

Checklist

Know your marginal rate and your effective rate · Pre-tax retirement and HSA contributions maximised where appropriate · Itemised total compared against the standard deduction each year · Bunching considered if near the line · Credits checked, especially refundable ones · Withholding reviewed after any change in income, marriage, or children.

Related: Self-employed and 1099 taxes · Where to hold what · When you need a CPA