The Internal Revenue Code allows taxpayers two main methods of reducing the amount of income tax that they pay each year. One is through deductions and the other is with credits. Each type of tax reduction is somewhat different in nature, but all items in each of the two categories have the same general effect on your tax return. However, one type of reduction has the potential to lower your tax bill a great deal more than the other.
As the name implies, a tax deduction is simply an amount based on a qualifying expense paid by the taxpayer during the year that is deducted, or subtracted from the taxpayer’s gross income. For example, a taxpayer with $30,000 of income who has a $2,000 deduction will only have to pay tax on $28,000 of income.
There are three main types of tax deductions. The first is known as “above-the-line” deductions that are listed in part II on page 1 of the 1040. These deductions include qualified moving expenses, student loan interest, the cost of health insurance premiums and one-half of any self-employment taxes paid by self-employed filers and many others. They are also known as deductions for adjusted gross income, because after they have been subtracted, the remaining amount of income is referred to as adjusted gross income, because the gross income has been “adjusted” by the above-the-line deductions.
Once the adjusted gross income has been computed, then the taxpayer is allowed to take either the Standard Deduction or else itemize deductions, depending upon which is larger. The Standard Deduction is a deduction automatically accorded to all taxpayers. The dollar amount varies according to filing status (i.e. the amount for marrieds filing jointly is always twice the amount given to single filers) and is indexed for inflation each year. This deduction is taken by all taxpayers whose total itemized deductions are less than the standard deduction for their filing status.
Below-the-line deductions are also known as itemized deductions. If this group of deductions collectively exceeds the taxpayer’s standard deduction, then the taxpayer can (and certainly should) claim them instead. Itemized deductions are reported on Schedule A of the 1040 and include items such as home mortgage interest, real estate taxes, personal property taxes and charitable contributions. This is the last group of deductions that are reported on the tax return.
Tax credits differ fundamentally from deductions in that they are not subtracted from the taxpayer’s taxable income. They are rather used to directly reduce the amount of actual tax owed on a dollar-for-dollar basis. For example, if the taxpayer in the example above who earned $30,000 had a $2,000 tax credit instead of a deduction, then assume that his or her tax bill comes out to $2,000. The $2,000 credit would effectively wipe this amount out and the taxpayer would have a tax bill of $0. Therefore this person would get back any and all amounts that were withheld for federal tax during the year. As a general financial rule of thumb, tax credits have approximately three times the financial impact of deductions. This is because deductions only reduce the amount of money that the taxpayer must report as income, while credits directly hit the bottom line on the tax return.
There are two types of tax credits. Nonrefundable credits are those whose excess amounts are simply lost. If the taxpayer’s tax bill in the above example was only $1,000, then the tax bill would be gone but a thousand dollars of the credit will go unused. Refundable tax credits will refund the difference to the taxpayer in cash. Therefore, if the $2,000 credit in the above example is refundable, then the taxpayer will get an additional thousand dollars on top of any withholding that is refunded. The major refundable tax credits include the Earned Income Credit and the Additional Child Tax Credit. Most other credits are nonrefundable. For more information on tax credits, visit the IRS website at www.irs.gov or consult your tax or financial adviser.