Anytime somebody mentions a tax “write-off”, it sounds pretty good. It means the money you’re spending now is money you don’t have to pay in taxes…right?
Not so fast.
The term tax “write-off” is thrown around too much. And, unfortunately, it’s deceiving. Many so-called “write-offs” are not dollar-for-dollar reductions of your tax bill. The term tax write-off may refer to tax credits, deductions, or adjustments…and they’re all different.
Here are the simple facts about the differences among tax deductions, adjustments, and credits and how they’ll affect your next tax return.
Adjustments (sometimes called “deductions to arrive at Adjusted Gross Income (AGI)” or “above the line deductions”) are certain expenses that directly reduce your income. After your total income is calculated, expenses that qualify as adjustments will be taken from that amount to arrive at AGI.
For taxpayers under 30, the most common adjustment is for student loan interest. For self-employed individuals, there are adjustments for self-employment health insurance and half of your self-employment tax. Other adjustments include alimony paid, IRA deductions, moving expenses, and educator expenses.
The amount of federal taxes that you pay—your tax bill—is calculated on your taxable income, not your AGI.
The lower your AGI, and, subsequently, your taxable income, the lower your tax bill will be. A common misunderstanding about adjustments is that they directly affect your federal tax bill; they do not. Adjustments do, however, reduce your AGI which can, in turn, lead to a smaller amount of tax.
The term deduction is usually short for itemized deductions (sometimes called “below the line deductions”).
Only those taxpayers that qualify for itemized deductions that are greater than the standard deduction should itemize. If you cannot itemize, you would instead claim the standard deduction, which is available to every individual taxpayer.
For individuals, that “write-off” term is most often used when people are referring to itemized deductions. Although it’s true that these deductions are write-offs, they are usually the least financially rewarding deduction of them all. As I mentioned earlier, itemized deductions should only be taken when the total deductions are greater than the standard deduction. From that, it’s easy to see that the only benefit you’re receiving from your itemized deductions are on those that exceed the amount of the standard deduction.
The most common itemized deduction is interest on a home mortgage loan. If you’re using this tax write-off to sway your decision to buy a home, you might think twice. The amount of money you spend on home mortgage interest will not lower your tax bill dollar for dollar. Instead, it will merely lower your taxable income.
The total amount of qualifying itemized deductions—which include expenses like local taxes, interest expense, charitable contributions, and medical expenses—are subtracted from your AGI. After you account for your personal exemptions, you’ll arrive at your taxable income, which is the amount that your tax bill is calculated on. Like adjustments, the most common misunderstanding about deductions is that they do not directly affect your federal tax bill.
Credits are arguably the most advantageous tax benefit available. Tax credits directly reduce your tax bill. For example, if you normally pay $6,000 in federal taxes every year, a credit for $2,000 would lower your bill to $4,000. It’s helpful to think of credits as an instant rebate on your tax bill.
Some of the more popular tax credits are the Credit for Child and Dependent Care expenses, the Child Credit, and education credits (like the Lifetime Learning Credit and the Hope Credit). Because most credits come with limitations, you may not be able to claim the entire amount of your expenses, but whatever you can claim will directly reduce your tax bill.
Every little bit helps…
In short, adjustments and deductions decrease our income (whether it’s AGI or taxable income) which indirectly decreases our tax bill. Tax credits directly reduce our tax bill. All of the above tax benefits are helpful in cutting our federal tax bill, they just accomplish the reduction in different ways.