As a taxpayer, each year you must file your federal tax return and see if you will owe taxes. You will typically owe taxes if you did not take enough taxes out of your paycheck or you were not making the necessary quarterly tax payments. One way you can lower the taxes you owe is through tax deductions and tax credits. Now both tax credits and tax deductions will lower the taxes you owe, but they are fundamentally different. Knowing the difference between the two is key when trying to figure out which ones to use to lower your tax liability.
A tax deduction is due to a tax-deductible expense or exemption which reduces your taxable income. This means that the deduction doesn’t lower the actual taxes you owe, but it lowers how much of your income is taxed. When calculating your tax deductions, you subtract the tax deductions from your income before you calculate the amount of taxes you owe. It’s important to realize that how much a deduction saves you depends on your income bracket. For example, if the deduction is worth $5,000 and you are in the 10% tax bracket, the deduction would reduce your taxes by $500. Because a tax deduction’s value is tied to the taxpayer’s tax rate, the higher your tax rate, the more the tax deduction will benefit you. A tax deduction is designed to offset the amount of income you’ll pay taxes on by writing off expenses. This ensures that you don’t pay taxes on certain income you’ve already spent, invested or lost.
There are two main ways to take tax deductions. First, a taxpayer can choose to take the standard deduction. This is the most popular choice by taxpayers as it is typically worth the most money. Your standard deduction is based on your filing status and is subtracted from your adjusted gross income. Second, taxpayers can choose to itemize their deductions. Itemizing is where taxpayers itemize their expenses that they incurred during the year and write them off on their return. For taxpayers that are wanting to itemize their taxes, it generally makes the most sense to itemize if their total deductible expenses are higher than the standard deduction. If you have a lot of expenses, it is worth the time to either add all the expenses you can deduct up and see if it reduces your taxable income more than the standard deduction. Taxpayers need to keep in mind that claiming certain deductions may be limited depending on your filing status and household income. If you’re unsure, you should contact a tax consultant to get assistance with filing your federal income tax return.
The most common tax deduction on your federal income tax return is the personal exemption. Almost all taxpayers will take this deduction, and those who don’t will itemize their deductions. Other tax deductions include student loan interest, medical and dental expenses, state and local income taxes and property taxes.
Unlike a tax deduction, a tax credit is subtracted straight from your tax liability, not your taxable income. A tax credit is a dollar-for-dollar reduction in the amount of taxes you owe. For instance, if you get a $1,000 tax credit and you owe $10,000 in taxes, you will now only owe $9,000. There is one important thing to remember when dealing with tax credits, there are refundable tax credits and non-refundable ones. When a tax credit is refundable, it means you can still get a tax refund from the government, even when your federal income tax bill is zero. For instance, if you owe $300 and get a refundable tax credit for $1,000, you will get a $700 tax refund now. IF you have left over money from a refundable tax credit, you will get that money back. One refundable tax credit is the Earned Income Tax Credit. Non-refundable tax credits can’t increase your tax refund, they can only reduce the amount of taxes you owe. So, using our example earlier, if you owe $300 and have the $1,000 non-refundable tax credit, that leftover $700 just goes away and doesn’t do anything. One good thing about tax credits is there are certain tax credits that you can claim even if you don’t owe any taxes.
The most common types of tax credits are the Earned Income Tax Credit, the Lifetime Learning Credit and the Saver’s Tax Credit.
Tax credits typically are the better choice between a tax deduction and a tax credit because a tax credit reduces your tax liability dollar for dollar, while a tax deduction lowers your taxable income, not the actual taxes you owe. It’s important to know all the tax deductions and tax credits available to you and how they can benefit you. It’s important to speak to a tax consultant that has prepared tax returns and is knowledgeable about tax law. Polston Tax can help. Our team of tax consultants and tax preparers can help determine the best tax deductions and tax credits for you and help you minimize the taxes you owe. Call us today at 844-841-9857 or click below to schedule your free consultation!