Personal Income Tax Credits and Deductions
1. Tax Credits vs. Tax Deductions
2. The Standard Deduction
3. Itemized Deductions
1. Tax Credits vs. Tax Deductions
As you know, tax credits and tax deductions can help reduce your overall income tax liability. Every year, millions of taxpayers search for credits and deductions that can help them save money. However, many people are under the impression that tax credits and tax deductions are the same thing. While they are similar in many ways, there are several key differences that you need to be aware of.
Most importantly, a tax deduction helps to reduce the amount of your taxable income (i.e. the amount of your income that is subject to tax). On the other hand, a tax credit helps reduce the actual amount of tax that you owe.
Tax Credits
Tax credits provide a dollar-for dollar reduction of your income tax liability. For instance, a $1,000 tax credit actually saves you $1,000 in taxes. A tax credit is always worth more than a dollar-equivalent tax deduction, because deductions are calculated using percentages. Referring to the numbers above, you can see that a $1,000 credit offers $750 more in savings than a $1,000 deduction.
Tax credits essentially reduce your liability dollar-for-dollar. That being said, they cannot reduce your income tax liability to less than zero. Simply put, your gross tax liability is the amount you are responsible for paying before any credits are applied.
The majority of tax credits are non-refundable. This means that any excess amount expires the year in which it is used, and is not refunded to you. There are some refundable tax credits, though. With these, your refund can grow.
To get a better idea of how tax credits work and whether or not you qualify, you need to know what is available to taxpayers in your situation. Some of the most common tax credits include: a credit for child and dependent care expenses, education tax credits, the earned income tax credit, adoption tax credit, and the foreign tax credit. Just because you qualify for one tax credit does not mean that you qualify for the rest. For example, the foreign tax credit is only available to those who pay taxes in a foreign country. Most Americans do not fit into this group, but may qualify for other credits.
How much are tax credits worth? Again, this depends on the particular credit you’re talking about. The Child Tax Credit, which is one of the most popular, can be worth up to $1,000.00 depending on your situation.
Just as the amount of each tax credit is different, so are the qualification guidelines. Since a tax credit is so helpful to the overall amount of money that you pay, it is essential that you are 100% accurate with the information you provide. If you are unsure of whether or not you’re eligible, it is better to check with a tax professional before including the tax credit on your return.
While tax credits are less common than tax deductions, they are available for things such as adopting a child, buying a first home, child care expenses, and caring for an elderly parent. Additionally, there are many business tax credits that you should also consider.
Tax Deductions
Tax deductions lower your taxable income and they are equal to the percentage of your marginal tax bracket. For instance, if you are in the 25% tax bracket, a $1,000 deduction saves you $250 in tax (0.25 x $1,000 = $250).
There are two main types of tax deductions: the standard deduction and itemized deductions. A taxpayer must use one or the other, but not both. It is generally recommended that you itemize deductions if their total is greater than the standard deduction.
The standard deduction is a dollar amount that reduces your taxable income. It is usually adjusted for inflation every year. Your standard tax deduction amount is based on your filing status, and it is subtracted from your AGI (adjusted gross income).
If you do not qualify for the standard tax deduction, you may choose to itemize your deductions. A taxpayer will also typically itemize tax deductions if it offers them more benefits than the standard deduction (i.e., when the total amount of qualified deductible expenses is greater than the standard deduction). Certain itemized deductions are based on a minimum (or “floor) amount. This means that you can only deduct amounts that exceed the specified “floor.” There is also an income limit for taxpayers who itemize.
Alternatively, above-the-line deductions are taken before your AGI is calculated (instead of after, like the other tax deductions). Above-the-line deductions are subtracted from your gross income, and the resulting number is your AGI. Above-the-line tax deductions apply whether you itemize or not.
The sum of your tax deductions, if itemized, is subtracted from your gross income. The number that is left is known as your adjusted gross income (AGI). Common tax deductions include: student loan interest, mortgage interest, traditional IRA contributions, tuition payments, and alimony payments. Of course, this is just a small sampling of the many deductions that may be available to you.
Conclusion
Both tax credits and tax deductions offer benefits. They are two different ways to reduce the amount of tax owed. Some people qualify for many tax credits and deductions, whereas others are not able to take advantage of nearly as much. As long as you are staying within the tax code of the IRS and you’re honest about your qualifications, you have nothing to worry about.
The main difference is that tax deductions are subtracted from your gross income, while tax credits are subtracted directly from the amount you owe. In short, this means that be able to claim a tax credit is usually better than a tax deduction.
All in all, both tax credits and deductions can help you pay less income tax. Your goal as a taxpayer should be to take full advantage of every tax credit and deduction that you qualify for. If you are unaware of which tax credits and deductions are available, hire a tax professional to show you the ropes.
2. The Standard Deduction
Tax deductions lower your taxable income and they are equal to the percentage of your marginal tax bracket. For instance, if you are in the 25% tax bracket, a $1,000 deduction saves you $250 in tax (0.25 x $1,000 = $250).
There are two main types of tax deductions: the standard deduction and itemized deductions. A taxpayer must use one or the other, but not both. It is generally recommended that you itemize deductions if their total is greater than the standard deduction.
Understanding the Standard Deduction
The standard deduction is a dollar amount that reduces your taxable income. It is usually adjusted for inflation every year. Your standard deduction amount is based on your filing status, and it is subtracted from your AGI (adjusted gross income).
The standard deduction for tax year 2010 is as follows (based on your filing status):
• Single: $5,700
• Head of Household: $8,400
• Married Filing Joint: $11,400
• Married Filing Separately: $5,700
• Qualifying Widow/Widower: $11,400
• Dependent: $950-$5,700
The standard deduction for tax year 2011 is as follows (based on your filing status):
• Single: $5,800
• Head of Household: $8,500
• Married Filing Joint: $11,600
• Married Filing Separately: $5,800
• Qualifying Widow/Widower: $11,600
• Dependent: $950-$5,800
The standard deduction for tax year 2012 is as follows (based on your filing status):
• Single: $5,950
• Head of Household: $8,700
• Married Filing Joint: $11,900
• Married Filing Separately: $5,950
• Qualifying Widow/Widower: $11,900
• Dependent: $950-$5,950
The standard deduction can be claimed on IRS Tax Form 1040, IRS Tax Form 1040A, or IRS Tax Form 1040EZ.
The standard deduction amount can change from year to year, and is based mainly on inflation.
Note that there is an additional standard tax deduction for people over the age of 65 and/or those who are blind? The deduction for the blind is allowed if you or your spouse is medically claimed to be totally or partially blind on the last day of the year.
An additional standard deduction for the elderly or visually impaired is as follows (for tax year 2010):
• $1,400 for single or head of household
• $1,100 for married filing jointly, married filing separately, or qualifying widow.
The additional amounts for 2011 are:
• $1,450 for single or head of household
• $1,150 for married filing jointly, married filing separately, or qualifying widow.
The additional amounts for 2012 are:
• $1,450 for single or head of household
• $1,150 for married filing jointly, married filing separately, or qualifying widow.
Other additions to the standard tax deductions are for: loss from a federally declared disaster, and local and state real estate taxes (up to $1,000 for joint filers), among others.
The amount of your standard deduction can be reduced if you are claimed as a dependant on another person’s return. In most cases, the amount of the deduction is the greater of your earned income for the year plus $300 or $950.
There are several groups of people who do not qualify for the standard deduction. They include: a married individual with “married filing separately” status and a spouse who is itemizing deductions, a person who is classified as a “nonresident alien,” and a person who has changed his accounting cycle and is not filing for a full 12-month period.
Understanding the standard tax deduction is very important. This makes it easier for you to decide whether taking the standard deduction or itemizing your deductions is the best route for you.
3. Itemized Deductions
Tax deductions lower your taxable income and they are equal to the percentage of your marginal tax bracket. For instance, if you are in the 25% tax bracket, a $1,000 deduction saves you $250 in tax (0.25 x $1,000 = $250).
There are two main types of tax deductions: the standard deduction and itemized deductions. A taxpayer must use one or the other, but not both. It is generally recommended that you itemize deductions if their total is greater than the standard deduction.
Understanding Itemized Deductions
There are certain expenses that qualify for a deduction on your income tax return. These are often times referred to as itemized deductions. If you do not qualify for the standard deduction, you may choose to itemize your tax deductions. In fact, many people never take the time to learn about itemized tax deductions because they rely on the standard deduction every year. While there is nothing wrong with this, you may be able to save even more money by itemizing.
While you may be interested in the standard tax deduction, you should note that there are several groups of taxpayers who are required to itemize. They include: a married person filing separately with a spouse who is itemizing, a person who is classified as a nonresident alien, and a person who has changed his accounting cycle and is not filing for a full 12-month period.
A taxpayer will also typically itemize deductions if it offers them more benefits than the standard deduction (i.e., when the total amount of qualified deductible expenses is greater than the standard deduction). As a general rule of thumb, if your itemized deductions are greater than the standard deduction, you should definitely itemize. Along with this, you may also want to employ itemized deductions if you find yourself in one of the following situations: you have substantial medical expenses, you pay taxes and interest on property, you have a lot of business expenses, or you have made big charitable contributions during the past tax year.
Some of the expenses that you may be able to include when itemizing your deductions are as follows: real estate taxes, personal property taxes, medical expenses, dental expenses, local and state income tax, home mortgage points, theft losses, charitable contributions, and job expenses. Of course, these are just a few of the more common itemized tax deductions. There are many others that you may be able to include, which will reduce your total amount of taxable income.
Certain itemized deductions are based on a minimum (or “floor”) amount. This means that you can only deduct amounts that exceed the specified “floor.” Miscellaneous itemized deductions, for example, are subject to a 2% floor. Simply put, this means your expenses are generally deductible to the extent that they exceed 2% of your AGI. Therefore, a taxpayer who with an AGI of $50,000 could claim itemized deductions for expenses/amounts over $1,000 (because 2% of $50,000 is $1,000). For medical expenses, however, you can only deduct amounts that exceed 7.5% of your AGI.
There is also an income limit for taxpayers who itemize. If your AGI exceeds $83,400 (for single and married filing separately) or $166,800 (for married filing jointly) then a portion of itemized deductions is not permitted.
If you decide to itemize your tax deductions, it is important to keep detailed records of those tax deductions ― including documentation for medical expenses, property taxes, charitable donations, interest expenses, and nonbusiness state income taxes.
You may use IRS Tax Form 1040 Schedule A to figure your itemized deductions, and attach it to your IRS Tax Form 1040 (but not Form 1040A or Form 1040EZ).
