No one likes the idea of paying more income tax than necessary, and understanding the different opportunities for reducing your tax bill could save you a significant amount of money each year. By using tax credits, deductions, and adjustments correctly, you can seriously cut down on the amount you hand over to the IRS.
The trouble is, there’s a lot of confusion when talking about these tax “write-offs.” While all three typically result in a lower tax bill, not all write-offs are created equal.
What are tax credits?
Unlike a deduction or adjustment that serves to reduce your taxable income, a credit directly lowers the amount you owe on your taxes. Since tax credits are responsible for this high-impact reduction on your tax bill, they provide the most benefit when it comes to how much you pay in taxes.
If you’re a parent, you’re likely already familiar with tax credits due to the popularity of the Child Tax Credit, and the Child and Dependent Care Credit. Governments also offer tax credits to promote specific behaviors, such as for replacing older appliances with new, energy-efficient models.
Why tax credits are important
Tax credits are your best shot to reduce your tax liability. When you qualify for a tax credit, you get an exact dollar-for-dollar reduction in the amount you owe.
For example, if you owe $3,000 in federal taxes, a qualifying credit of $2,000 would lower your tax bill to $1,000, which leaves more money in your pocket.
There are three different types of tax credits:
- Nonrefundable Tax Credits are deducted from your tax bill until the amount you owe equals zero. That means if you owed $4,000 in taxes and got a $4,500 tax credit, you’d end up owing $0 in taxes, but you don’t get to keep the extra $500 from the credit.
- Refundable Tax Credits are entirely refundable and provide the highest benefit because, regardless of what you might owe, you get the entire amount of the credit. For instance, if your tax bill was $4,000 and you received a $4,500 tax credit, you’d end up owing $0, plus the extra $500 would be paid to you, too.
- Partially Refundable Tax Credits fall somewhere between the two, with 40% of a partially refundable tax credit being refundable and the other 60% being nonrefundable. For example, the $2,500 American Opportunity Tax Credit is partially refundable, so up to $1,000 of that credit can be paid out to you, even if your tax bill has already been reduced to $0.
How to spot tax credits
Once you understand the three different kinds of tax credits, you can begin to sort through which ones are most beneficial for you. The IRS website has a generous list of tax credits for individuals categorized by family size, whether or not you’re a homeowner, how much you paid for health care or education expenses, etc.
A few tax credits you may already be familiar with include:
- Earned Income Tax Credit
- Low-Income Housing Credit
- Child and Dependent Care Credit
- American Opportunity Tax Credit
- Education Credit
It’s best to work with a tax professional to determine your eligibility for these and other credits offered by the government. Or, you could use tax software such as Turbo Tax, H&R Block, or Cash App.
What are deductions?
When talking about tax “write-offs,” people are usually referring to deductions. As a shortened way of saying an itemized deduction, which are also known as below-the-line deductions, tax deductions reduce your tax bill but don’t provide a dollar-for-dollar match like a tax credit does.
Instead, deductions lower the amount of your taxable income. Depending on which tax bracket you fall into, you could save more or less on a deduction than someone with a higher or lower income.
To determine the impact a deduction might have on how much you owe, you multiply the amount of your deduction by your tax bracket. For instance, if you have a $6,000 deduction and are in the 10% tax bracket, you’d pay $600 less in taxes.
Read more: Income tax brackets (marginal tax rates)
Why deductions are important
Designed to offset how much you owe in taxes, a deduction applies when you pay for expenses like tuition, healthcare, retirement contributions, and any self-employment gains or losses you had throughout the tax year.
Before you gather up all your receipts, know that you should only take these types of itemized deductions if your total deduction amount is greater than the standard deduction you get automatically. For tax year 2022, the standard deduction is $12,950 for individuals.
How to spot deductions
The most common tax deduction is the amount of interest you pay on a home mortgage loan. As previously mentioned, deductions don’t reduce your tax bill dollar-for-dollar, but they do lower your taxable income which, in turn, will decrease the amount you owe.
Generally, deductions don’t provide a tax benefit unless you’re spending an enormous amount in qualifying expenses. They’re only beneficial if your costs go above the standard deduction amount, which isn’t a common occurrence for most.
What are adjustments?
Adjustments are another category of tax “write-offs” that reduce your total, or gross income. Though they’re used to lower your overall tax liability, you don’t go through the complicated and time-consuming process of itemizing them. Instead, adjustments are directly deducted from your gross income and are used to arrive at your Adjusted Gross Income (AGI).
Why they’re important
Your AGI is an important factor, perhaps even more critical than your taxable income, since it determines the different deductions and credits for which you’re eligible. Understanding how adjustments impact your income helps to reduce the amount of taxable income that you report on your tax return.
As more adjustments are subtracted from your income, your AGI becomes a lower amount, too. Even though adjustments don’t directly impact the amount of taxes you owe, it does change your AGI. Since that’s what is used to determine your tax bracket and the percentage of income tax you pay, a lower AGI means a lower tax bill.
How to spot adjustments
It might come as a surprise to you that the standard “Student Loan Interest Deduction” is a tax adjustment and not a deduction at all. The amount you pay in student loan interest is used to adjust your gross income to arrive at your AGI.
Other common adjustments include:
- IRA contributions
- If you’re self-employed, half of the self-employment taxes you pay
When calculating the amount you owe for taxes, keep in mind there are weighty differences between deductions, credits, and adjustments. Taking the time to understand these differences and how they work together will significantly reduce your overall tax bill.
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