Taxes can be confusing, and this topic is one of those reasons. Deductions and credits help you lower your tax bill, but many people misunderstand how they work. Deductions are good; credits are better.
Deductions vs. Credits
Deductions lower your taxable income. For example, when you put $2,000 into your 401k, you avoid paying tax on that $2,000. On the other hand, tax credits are used to pay your tax bill. For example, if you qualify for a $1,000 tax credit, you save $1,000. For this reason, tax credits are drastically better but also harder to come by.
Best of all, a select few credits are refundable. If a credit is refundable, your tax refund will be more than the tax you pay.
I like Kohls. I can always find a $4 clearance shirt that quickly becomes one of my favorite shirts. Kohls is also known for Kohls cash. Kohls cash is an excellent analogy for tax credits. When you shop at Kohls, they reward you with money off your next visit in the form of “Kohls Cash.”
This $10 entices you to come in and buy something. If you buy $50 worth of merchandise, you only pay $40. This is how tax credits work. If your tax bill is $1000 and you have a $600 tax credit, you will only pay $400.
There is a downside to Kohl’s cash. It has no monetary value. If you have $10 and only spend $5, you do not get the unspent $5. Refundable tax credits do not work this way. With a refundable tax credit, you keep the balance. For example, if your tax bill is $1000, but you have a $1500 tax credit, you will receive a $500 refund.
The most well known refundable tax credit is the Earned Income Tax Credit. It is for mid to low-income families that have earned income.
Most tax credits are not refundable.
Deductions: Standard vs. Itemized
Tax deductions, on the other hand, do not offset taxes but lower your taxable income. Like in the example above, when you contribute to your 401k.
When filing taxes, you have the choice of either a standard deduction or an itemized deduction. With the itemized deduction, you total your deductible expenses. The total is your deduction.
The standard deduction is more straightforward. If you are single, you can deduct $12,200 regardless of your actual expenses. If you are married, it doubles to $14,400.
It goes without saying; you would choose the higher option. For most families, the standard deductible is much higher.
What is deductible?
Some common deductions to itemize are:
- Charitable contributions
- Medical expenses (above 10% of your income)
- Mortgage interest and points
- State, local or sales tax
As you can see, it would be hard for many average-income households to have $24,400 in deductible expenses (unless food someday gets added to the list).
There Are Some Deductions With Value
Above the line, deductions work differently. Above the line, deductions come off your income on top of the itemized or standard deduction. Not only are they on top of the standard deduction, but they also adjust your Adjusted Gross Income (AGI). Since they decrease your AGI, they may help you qualify for tax credits and even lower your student loan payments.
Some great above the line deductions are:
- sponsored health insurance
- Traditional 401k, 403b, IRA or other tax-deferred retirement savings
- Health Savings Accounts (HSA)
- Flexible Savings Accounts (FSA)
- Dependent Care FSA
With this much going on in your taxes, your tax preparer must do two things — first, a good job looking over your past year. Second, give you proper guidance for the current year.
If you are looking for someone to help you make decisions to lower your tax bill proactively, Family Life Financial Planning is here to help.