It's that time of year again. Tax time.
Hopefully, you have a tax preparer that helps you file your taxes. A tax preparer not only alleviates the burden of filling in your return, but also can help make sure you utilize all the tax deductions and tax credits available to you.
These deductions and credits help lower your tax burden.
It’s important to understand the key difference between these two terms.
So, what Are Tax Credits?
Simply, tax credits reduce the amount of actual tax owed. Tax credits don't really affect your tax bracket or taxable income. Instead, think of these credits as a way to reduce the taxes owed after you’ve determined how much you owe the IRS. Here are the more common types of tax credits that can be given based on things like your income, if you have a kid in college, whether or not you have children, and more. These credits include:
- Child Tax Credit
- Child and Dependent Care Credit
- Lifetime Learning Credit
- Adoption Credit
- Earned Income Tax Credit
- Residential Energy Tax Credit
Tax credits are typically either refundable or non-refundable. Depending on which type of credit it is, this will affect how much you’ll receive in a tax refund or reduce what you need to pay.
Refundable Tax Credits
Refundable tax credits are tax credits that allow you to be refunded the remaining, unused portion of a credit. For example, say you owe $1000 in taxes, but your eligible child tax credit is worth $2,000. Not only will this cover the $1000 you owe in taxes, but you will also be refunded the remaining $1,000 (or reduced from any additional tax you are required to pay).
Non-Refundable Tax Credits
Alternatively, non-refundable tax credits will only cover the taxes you owe, up to the credit’s limit. If there is more in the credit amount than what you owe, you do not receive the excess amount in the form of a tax refund. For example, if you owe $900 in taxes and your tax credit is worth up to $2,000, the $900 will be covered but you will not receive the additional $1,100.
So, What Are Tax Deductions?
Still not bad, but not nearly as good as a credit as deductions aren't a dollar for dollar reduction like in a tax credit. Tax deductions are used to reduce the amount of income that’s eligible to be taxed. By reducing this amount, your income may fall into a lesser tax bracket (still pretty good), meaning you’re subject to pay a lesser tax percentage. There are typically two types of tax deductions: itemized deductions and above-the-line deductions.
You can use itemized deductions to help lower your taxable income. Common types of itemized deductions include:
- Charitable donations There is still charitable deduction up to a certain limit even if you don't itemize for 2021
- Medical expenses
- Property taxes
- Mortgage interest
While people are welcome to add each deduction up separately on their taxes (i.e. itemize them), most will opt for the standard deduction set by the IRS. For the 2022 income tax year, these are the standard deduction amounts:
- Single or married but filing separately: $12,950
- Married and filing jointly or qualifying widow(er): $25,900
- Head of household: $19,4001
It is common to use a standard deduction because, in most cases, an itemized amount won’t exceed the IRS’s standard deduction rates. One can also "bunch deductions" in a particular year and itemize but that's for another article.
Above-the-line deductions are used to reduce your adjusted gross income (AGI), which can qualify you for certain itemized deductions and tax credits. Your adjusted gross income is determined by subtracting above-the-line deductions from your gross income. This lower AGI can then allow you to claim important tax credits or deductions that may be dependent on income level.
Lowering your AGI can be a great strategy and it can open other planning opportunities such as making a Roth IRA contribution or lowering taxes on Social Security benefits.
Common above-the-line deductions include:
- Alimony paid (if divorce was finalized by December 31, 2018)
- Educator expenses
- Student loan interest
- Deductible IRA contributions
- Moving expenses of armed forces members
Tax credits and tax deductions can both greatly benefit taxpayers, especially when they work in tandem. If you are not using a qualified tax preparer, (and we strongly recommend you do), you should familiarize yourself with the difference between these two tax terms which gives you a great place to start researching and understanding what deductions and credits you and your spouse may be eligible for in the upcoming tax year.
Before making any decisions, it is always best to speak with a Certified Financial Planner™ practitioner to learn what your options are. Specific tax questions should be brought up with your tax preparer.
Feel free to reach out to me if you have any questions.
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Another article of interest, pertaining to tax penalties, Wait. A 50% tax penalty on top of regular taxes?
All the best.
Rick Fingerman, CFP®, CDFA™, CCFS®
Financial Planning Solutions, LLC (FPS) is a Registered Investment Advisor. Financial Planning Solutions, LLC (FPS) provides this blog for informational and educational purposes only. Nothing in this blog should be considered investment, tax, or legal advice. FPS only renders personalized advice to each client. Information herein includes opinions and source information that is believed to be reliable. However, such information may not be independently verified by FPS. Please see important disclosures link at the bottom of this page.