The weather is finally warm and weeds are climbing out of the soil, so let’s dive into Tuesday Tax Tip.
The federal tax code is complex and terminology can be confusing. Take a look at tax credits and tax deductions, both can cut how much you owe in federal taxes, though they do it differently. Tax credits are generally more favorable because it reduces your tax liability dollar for dollar, versus a tax deduction which lowers your taxable income.
A tax credit reduces the amount of taxes you owe. In other words, a tax credit is a dollar-for-dollar reduction of taxes owed. Some tax credits are refundable which means you can get a tax refund, even if you have no tax liability. (I’ll go over refundable and nonrefundable tax credits at a later date.)
Example: Based upon Jimmy’s taxable income, he owes $30,000 in federal taxes. He qualifies for $5,000 tax credit. Therefore, he only owes $25,000 in taxes.
Here are a few types of tax credits: Child Tax Credit, Child and Dependent Care Credit, Retirement Savings Contributions Credit and Hope and Lifetime Learning education credits.
A tax deduction reduces your income that is subject to taxes. Specifically, it reduces your adjusted gross income (AGI) which is used to determine your taxable income. Then your taxable income is used to calculate taxes owed. (Got that?)
Example: Using fictitious numbers and tax rates, assume Jimmy has adjusted gross income is $100,000 and deductions of $50,000, resulting in taxable income of $50,000. Based upon a 55% tax rate, he owes $27,500 in taxes.
If he includes an additional $2,000 tax deduction, his taxable income is now $48,000. Using the same 55% tax rate, his new taxes owed is 26,400. In other words, a $2,000 tax deduction lowered his tax bill by $1,100. Unlike a tax credit, he did not get a dollar for dollar reduction in his tax liability.
Here are a few types of tax deductions: Student Loan Interest, Health Savings Account, Penalty, Charitable Donations and Individual Retirement Account (IRA) contributions.
Note: State and federal taxes can be confusing and complex, you should contact your tax advisor on what you can and can not include on your tax return.