Tax Foundation: Deductions and Credits Made Easy
The world of taxes is not necessarily simple, but understanding many of its basic concepts-such as deductions and credits-serve as a foundation for effective tax planning. In fact, even though both deductions and credits reduce tax liability, they are reduced in somewhat different ways. An understanding of the mechanics behind how they work can help individuals preserve maximum savings and make better financial decisions.
What is a Tax Deduction?
Tax deductions reduce the amount of income earned that is collected as taxes. Simply, they reduce your taxable income, and therefore your tax liability is lowered. Under this category fall three types: standard deductions, itemized deductions, and above-the-line deductions.
Standard Deduction. The standard deduction is the total amount that the IRS allows taxpayers to subtract from their income and where no other itemized deductions apply. For 2023, one example of standard deduction made available to any taxpayer is $13,850 for single filers, or $27,700 for married couples who choose a joint filing. Many people take advantage of this automatic method, as it is often easier than determining and adding up various itemized deductions.
Another type of deduction is the itemized deduction, where taxpayers may itemize certain expenses in attempting to subtract such expenses from taxable income that is reported. Taxpayers have two options for deductions-the standard deduction or itemizing, with a taxpayer’s choice typically depending upon the option that will result in the lowest tax bill. The expense records must be detailed if a taxpayer decides to itemize because these specific deductions may be audited and even contested by the IRS.
Above-the-line deductions-Contributions to retirement accounts, interest on student loans-only can be taken regardless of your itemizing or taking the standard deduction. These are particularly helpful, because they lower your AGI; this, in turn may make you eligible for even more tax credits.
What Are Tax Credits?
Tax credits are unlike deductions in a way that reduces your tax liability dollar for dollar. What it means is that the dollar amount of the tax credit reduces the tax directly payable, so, in principle, a tax credit is more valuable than a deduction. Two primary categories of tax credits exist, namely refundable and non-refundable.
Nonrefundable tax credits do not reduce tax payments below zero. You can apply a non-refundable credit to zero out your tax liability, but you don’t recover any unused credit. For example, suppose you owe $500 in tax and have a $600 non-refundable credit. Your tax bill would be reduced to zero, but you’d lose the extra $100.
Refundable tax credits allow you to get back the overage amount above your liability. For instance, if you have a $500 tax liability and there is a refundable credit of $600, your tax liability would be wiped out, and you would receive $100 in refund. There are EITC and Child Tax Credit within this category.
Strategic Tax Planning
This distinction between deductions and credits will bear significant implications for your overall tax strategy. Taxpayers should review their situation every year and consider whether taking the standard deduction, if available, or itemizing will be the best step forward. Knowing about the tax credits available can save taxpayers hundreds of dollars.
Individuals should also contribute to retirement accounts for over the line contributions and improve the client’s potential eligibility for other credits. Proper record-keeping and review of the issues with a professional tax consultant will further enhance tax planning to ensure that all deductions and credits available are taken advantage of.
Conclusion
In other words, the most universal aspect of management with respect to taxation is having an understanding of what tax deductions and credits are. Deductions reduce a taxpayer’s taxable income, whereas credits cut down on actual taxes due, so these are even more attractive. Understanding these components enables individuals to make the best of the savings in taxes or allow more intelligent decisions that work to help them with their overall financial well-being.