Taxes can sometimes feel like an unruly maze, with the path to understanding buried beneath complex terminology. However, mastering two key concepts, deductions and credits, can go a long way in helping you minimize your tax bill. What is the rule of thumb to remember? Deductions are beneficial, but credits are your real game-changers.
Decoding Deductions and Credits
In the world of taxation, deductions serve to lower your taxable income. Take, for instance, the act of contributing $2,000 into your 401k; this means you bypass tax on that $2,000.
On the other hand, tax credits are a direct way to offset your tax bill. Suppose you qualify for a $1,000 tax credit. This essentially means you save $1,000 off your tax bill. This fundamental difference makes tax credits not only superior but also more elusive.
The icing on the tax cake? Some tax credits are refundable, leading to a tax refund that surpasses the tax you owe.
Tax Credits Explained with a Shopping Analogy
Consider your shopping trips to Kohl’s. Kohl’s reward system, known as Kohl’s Cash, sets it apart. This discount system is an excellent metaphor for tax credits.
You earn Kohl’s Cash on shopping trips, a $10 coupon that tempts you to return. When you do and spend $50 on your next shopping spree, your total comes down to $40, thanks to your Kohl’s Cash. Tax credits operate similarly. A tax bill of $1000 is reduced to $400 with a $600 tax credit.
The catch with Kohl’s Cash is that it doesn’t offer real money value. If you spend only $5 out of the $10, you lose the remaining $5. The same is valid for tax credits. You do not keep the unused portion of a tax credit.
However, refundable tax credits are more generous. If you have a $1500 tax credit but only owe $1000 in tax, you will receive the extra $500 as a refund. The Earned Income Tax Credit, designed for mid to low-income families with earned income, is a well-known refundable credit. While some tax credits are refundable, most aren’t, limiting you to offset only the tax you owe.
Navigating Tax Deductions: Standard versus Itemized
Unlike tax credits, tax deductions lower your taxable income. As explained before, contributing to your 401k is a deduction.
When filing your taxes, you have two options: a standard deduction or itemizing your deductions. The latter involves tallying your deductible expenses to calculate your total deduction. The standard deduction offers simplicity. If you’re single, you can claim a $13,850 deduction, regardless of your costs. For married couples, this value doubles to $27,700.
Naturally, you’d opt for the higher value, which, for most families, happens to be the standard deduction.
What Qualifies as a Deductible Expense?
Several ordinary expenses qualify for itemization, including charitable contributions, medical payments (above 10% of your income), mortgage interest and points, and state, local, or sales tax. Given the high standard deduction, many average-income households find reaching $27,700 in such expenses challenging.
The Added Value of Certain Deductions
Certain deductions, known as ‘above the line,’ offer distinct benefits. They decrease your Adjusted Gross Income (AGI), potentially qualifying you for tax credits and lowering student loan payments. Plus, they’re applied on top of your chosen standard or itemized deduction.
Some of these ‘above the line’ deductions include:
- Employer-sponsored health insurance
- Traditional 401k, 403b, IRA, or other tax-deferred retirement savings
- Health Savings Accounts (HSA)
- Flexible Savings Accounts (FSA)
- Dependent Care FSA
- Student Loan Interest
Navigating your taxes can be complex, and having an experienced tax preparer in your corner is crucial. They should scrutinize your past year’s financial activities and provide clear guidance for the current year.
At Family Life Financial Planning, we’re dedicated to assisting you in making proactive decisions to lower your tax bill. Contact us today, and let’s turn tax confusion into tax savings.
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For informational purposes only. It is important to consult a professional before implementing any strategies or ideas.