Disclaimer: I am not a CPA or a lawyer, and this post should not be taken as legal or financial advice.
I like to talk about taxes because taxes matter A LOT when you’re trying to figure out how to optimize your finances. I’ve talked before about why you should care about taxes and why different kinds of tax-advantaged accounts are better than others (and how there’s only one unicorn account!). As we get closer to the end of the year, I’m going to be discussing more tax topics. Before we delve deeper, I need to cover some basics. Let’s start with the most important lesson…
The most important thing you need to understand about income taxes is the difference between a tax deduction and a tax credit.
What is a Tax Deduction?
A tax deduction is a reduction in the amount of income that you will pay tax on. So for example, if you have an income of $50,000 and you qualify for a tax deduction of $5,000, you will pay a percentage of $45,000 as your taxes instead of a percentage of the full $50,000.
Itemized vs Standard Deduction
Whether you realize it or not, you’re already taking at least one deduction. Everyone takes either the standard deduction or itemized deductions. The standard deduction is the amount that everyone can subtract from their income as non-taxable, based on their filing status. For 2015 taxes, that amount was $6,300 for someone filing singly and $12,600 for a married couple filing jointly. Check out the IRS information if you want more details on the amounts of standard deductions.
If you have kept records and your itemized deductions are greater than your standard deduction, you can choose to file a Schedule A to take the itemized deduction instead.
What Can You Deduct on the Schedule A?
Common items included on a Schedule A as itemized deductions include
- Taxes paid: You can deduct local and state taxes and real estate taxes.
- Interest paid: Mortgage interest, private mortgage insurance, and loan origination fees are deductible here, with limits.
- Medical expenses: If you have excessive medical expensive (exceeding a threshold of 10% of your income for those under 65), then you can deduct the expenses over the threshold. Unfortunately, this generally only applies to those with pretty extreme medical expenses.
- Charitable contributions: Gifts to qualified charities of cash, property, and vehicles are all deductible, but record-keeping is very important.
- Job expenses: Expenses from your job fall under “miscellaneous deductions” (with a threshold of 2% of your income), but they can really add up for employees who have things like non-reimbursed work travel expenses or expensive uniforms.
In some areas of the country, like my home state of Ohio, state income taxes, local income taxes, and real estate taxes add up to such a high amount that almost every homeowner would benefit from itemizing their deductions. If you live in an area with low local taxes, you may not ever benefit from itemizing unless you give an unusually high amount to charity or have extreme job-related expenses.
Many people like to refer to things as being “tax deductible” but if they fall into one of the itemized deduction categories, then only people who itemize could benefit. This can be really deceiving. For example, when I was working as a tax preparer, I had one client who was working as a pizza delivery driver. His boss had assured him that his car expenses would be tax deductible, and they are as job expenses… but as a single young man who doesn’t own a home, he had nothing else to add to his list of itemized deductions. Since his itemized deduction would be much less than the standard deduction, he did not itemize and he gained nothing by having vehicle expenses. He felt tricked by his boss!
By understanding your personal tax situation, you can be better prepared to know whether something will benefit you on your taxes or not.
Deductions That Don’t Require Itemization
The good news is that there are some deductions that you can take without itemizing and filing a Schedule A. If you meet the qualifications of the particular deduction, you can take it, even if you have none of the other Schedule A deductions listed above. The most common of these include:
- Student Loan Interest: If you’re paying on student loans, you can subtract the interest you paid during the year from your taxable income, up to $2,500.
- Educator Expenses: If you’re a qualified teacher, you can deduct up to $250 of classroom expenses from your income.
- Tuition and Fees Deduction: College tuition can be taken as a deduction, but this is rarely a better deal than the educational credits (and they can’t both be taken).
- Moving expenses: Expenses due to a long distance move for work purposes are deductible.
How Is a Tax Credit Different from a Tax Deduction?
A tax credit directly reduces the amount of taxes you pay, while a tax deduction reduces the amount of income you pay taxes on. This is a VERY IMPORTANT difference. For example, if you’re in the 25% income tax bracket and you have a choice between a tax deduction of $1,000 or a tax credit of $1,000, which should you take? Well, the tax deduction would reduce your taxable income by $1,000, saving you $250 in taxes while the tax credit would save you $1,000 in taxes. Tax credits are almost always a better deal!
Can I Get a Tax Credit if I Don’t Owe Any Taxes?
Yes, you can! Some credits are refundable, which means that you can get them back in a refund (either fully or partially), even if you don’t owe any taxes.
What Can I Get Tax Credits for?
Common non-refundable tax credits include:
- Credit for Child and Dependent Care Expenses: If you’re paying for childcare so that you can work, you may be able to get a tax credit to help offset these costs.
- Lifetime Learning Credit: You may be eligible for this credit if you paid for college tuition, even if you’re not working towards a degree.
- Retirement Savings Contribution Credit: Lower income families who contribute to retirement accounts can qualify for this credit.
- Child Tax Credit: Worth up to $1000 per child, this credit is not refundable, but if you aren’t able to take the full credit because you owe no tax, you may qualify to take the additional child tax credit instead.
Common refundable tax credits include:
- Earned Income Tax Credit (EITC): This credit is the most valuable tax credit (maxing out at over $6,000) and is available to lower-income families who have earned income from employment.
- American Opportunity Tax Credit (AOTC): The AOTC is for college tuition for students who have not yet completed a 4-year degree, can be worth up to $2,500/year (or $10,000/lifetime), and is partially refundable.
- Additional Child Tax Credit: If a family owes no tax and isn’t able to claim the full amount of the Child Tax Credit, they may be able to claim the Additional Child Tax Credit, which is refundable. Essentially, this makes the Child Tax Credit “partially refundable”.
Credits > Deductions
Tax credits are almost always better than deductions, and if you qualify for a tax credit, you should definitely take it!
I hope you’ve enjoyed the most important lesson on taxes! Are you planning to claim any tax credits this year? Comment below.