Tax deductions vs tax credits
There are tax deductions and tax credits. The difference between tax deductions and tax credits is huge. These will provide important tax benefits that can help reduce your tax bill.
Tax deductions lower your taxable income by reducing the income that is subject to tax. For example, if you claim a $1,000 deduction, and your marginal tax rate is 25%, you will save $250 in taxes.
With tax credits, you save dollar for dollar. For example, if you claim a $1,000 credit, you will save $1,000 in taxes. Tax credits can be refundable or non-refundable, which means if the credit amount is more than your tax liability, the nonrefundable credit will only reduce your tax liability to zero. Your ability to qualify for a particular tax credit depends on several factors, including your income, age, and tax filing status.
Understanding Tax Deductions: What They Are and How They Benefit You
Tax deductions are a way for taxpayers to reduce their taxable income and lower their overall tax bill. When you file your tax return, you first calculate your total income (excluding tax-exempt income). Then, you subtract any deductions to determine your taxable income. Your tax is calculated using tax tables or rates based on this reduced amount. Later, you can subtract any tax credits or payments you’ve already made.
In short, the more deductions you claim, the less taxable your income. This means you’ll either pay less in taxes or receive a bigger refund.
Type of tax deductions
There are different types of tax deductions to help reduce your taxable income. One common type is the Standard Deduction, which is a fixed amount based on your filing status. Another option is itemized deductions, which include specific expenses such as:
- Medical and dental costs
- State and local taxes
- Home mortgage interest
- Charitable donations
- Losses from theft or natural disasters
However, you must choose between the Standard Deduction and itemized deductions—you can’t claim both. You can select whichever option gives you the bigger tax benefit.
In addition, there are above-the-line deductions, which you can claim no matter whether you take the Standard Deduction or itemize. These deductions are listed on your tax return just before calculating your adjusted gross income (AGI).
Above-the-line deductions are especially helpful because they reduce your AGI. A lower AGI can make you eligible for other tax breaks, leading to even more savings. Popular above-the-line deductions include:
- Contributions to individual retirement accounts (IRAs)
- Contributions to health savings accounts (HSAs)
- Student loan interest payments
- Educator expenses
- Health insurance premiums for the self-employed
Finally, if you’re a sole proprietor, you can claim business deductions and the qualified business income deduction on Schedule C. While this article focuses on non-business deductions, it’s worth noting that sole proprietors can claim business-related deductions on their individual tax returns.
Tax Deductions vs. Tax Credits
Both tax deductions and tax credits can reduce your income tax bill, but they work in different ways. While deductions are helpful, tax credits generally offer greater savings.
Tax deductions lower your taxable income, which indirectly reduces the tax you owe. However, the actual savings depend on your tax bracket. For example, if you’re in the 22% tax bracket and claim a $1,000 IRA deduction, your tax liability decreases by $220 ($1,000 × 22%).
In contrast, tax credits directly reduce the amount of tax you owe on a dollar-for-dollar basis. For instance, a $1,000 tax credit reduces your tax bill by the full $1,000.
There are two types of tax credits: refundable and nonrefundable:
- Refundable Credits: If the credit is more than the tax you owe, you’ll receive the remaining amount as a refund. For example, if you owe $2,000 in taxes and qualify for a $2,500 refundable credit, you’ll get a $500 refund.
- Nonrefundable Credits: These can only reduce your tax bill to zero. If your tax liability is $2,000 and you have a $2,500 nonrefundable credit, your tax is reduced to $0, but the extra $500 won’t be refunded.
In summary, while deductions reduce the taxable income used to calculate your taxes, credits directly lower the amount of tax you owe, often making them a more powerful tool for saving money.
Navigating Tax Credits: How They Differ from Deductions and How to Claim Them
For example, if you claim a $1,000 credit and owe $4,000 in taxes, your tax bill will be reduced to $3,000. Tax credits can be more valuable than deductions because they can save you more money.
A refundable credit means that if the credit amount exceeds your tax liability, the government will give you the remaining amount as a refund. A non-refundable credit, on the other hand, will only reduce your tax liability to zero, and you can’t receive a refund for the unused credit.
Child Tax Credit: This credit is available to taxpayers with a qualifying child under 17. The credit amount is $2,000 per child, and up to $1,400 can be refundable.
American Opportunity Tax Credit: This credit is available to taxpayers paying for college or vocational school. The credit amount is up to $2,500 per student and is partially refundable.
Lifetime Learning Credit: This credit is available to taxpayers paying for undergraduate, graduate, or professional degree courses or courses to acquire or improve job skills. The credit amount is up to $2,000 per tax return and is non-refundable. The credit amount is based on your income and the cost of care.
Adoption Credit: This credit is available to taxpayers who adopt a child. The credit amount is up to $14,440 per child and is non-refundable.
Education Tax Credits: Understanding the American Opportunity Tax Credit and Lifetime Learning Credit
For 2024, the American Opportunity Tax Credit (AOTC) remains a refundable credit of up to $2,500 per eligible student for qualified education expenses paid during the first four years of higher education. Up to $1,000 of this credit can be refunded even if you owe no taxes. To qualify, the student must be pursuing a degree or recognized education credential and be enrolled at least half-time during the academic period.
Additionally, the student’s modified adjusted gross income (MAGI) must remain below the current thresholds: $90,000 or less for single filers and $180,000 or less for married couples filing jointly.
The Lifetime Learning Credit (LLC) is a nonrefundable credit of up to $2,000 per tax return per year for a wide range of post-secondary education expenses. This includes undergraduate, graduate, or professional degree courses and courses taken to improve job skills.
Unlike the AOTC, the student must not pursue a degree or be enrolled full-time to claim this credit. However, MAGI must be at most $73,000 for single filers or $146,000 for married couples filing jointly in 2024.
You must also provide documentation such as tuition statements (Form 1098-T) and receipts for education-related expenses like books and supplies.
Child Tax Credit vs. Child and Dependent Care Credit: Which One Applies to You?
The Child Tax Credit for 2024 provides a credit of up to $2,000 per qualifying child under age 17. Up to $1,600 of the credit is refundable, meaning you could receive a portion as a refund even if you owe no taxes. To qualify, the child must have a valid Social Security Number, and your MAGI must not exceed $200,000 for single filers or $400,000 for married couples filing jointly.
In contrast, the Child and Dependent Care Credit offers up to 35% of eligible expenses for the care of a qualifying child under age 13 or a dependent who cannot care for themselves. For 2024, the maximum eligible expenses are $3,000 for one dependent or $6,000 for two or more dependents, resulting in a maximum credit of $1,050 or $2,100, respectively. This credit is non-refundable, meaning it can only reduce your tax liability but not generate a refund.
If you cannot claim the Child Tax Credit, you should review the IRS website to check the current guidelines and tools, like the Child Tax Credit Update Portal, to ensure you receive the correct benefits.
Charitable Contributions: How to Properly Deduct Donations on Your Tax Return
For 2024, it’s important to understand the rules and regulations for deducting donations on your tax return to maximize your benefits while staying compliant.
First, it’s important to note that you must deduct charitable contributions. This means you cannot claim a charitable contribution deduction if you take the standard deduction.
Next, the organization you donate to must be a qualified charitable organization. This includes most religious, charitable, educational, scientific, or literary organizations and organizations that work to prevent cruelty to children or animals. You can check the tax-exempt status of an organization using the IRS’s Exempt Organizations Select Check tool.
You will also need to keep records of your donations. Donations of cash or property valued at less than $250, a canceled check, bank or credit card statement, or written communication from the charity showing the name of the charity, the date, and the amount of the contribution is enough. For donations of cash or property valued at $250 or more, you will need a written acknowledgment from the charity that includes the amount of the donation and whether the charity will depend on the type of donation and the type of property donated.
For example, donations of cash or property that have been used for a charitable purpose are generally deductible at fair market value, while donations of appreciated capital assets are generally deductible at fair market value, subject to certain limits.
In 2024, the deduction limit for cash donations is 60% of your Adjusted Gross Income (AGI). For donations of appreciated assets, the limit is typically 30% of AGI.
Homeowner Tax Deductions: Mortgage Interest, Property Taxes, and More
As a homeowner in 2024, you can claim several tax deductions to reduce the cost of homeownership and lower your tax liability.
One of the most significant deductions available is the mortgage interest deduction. For mortgages taken out before December 15, 2017, interest on loans up to $1 million can be deducted. For mortgages originating after that date, the limit is $750,000.
The property tax deduction allows you to deduct state and local property taxes paid on your primary residence. However, under the Tax Cuts and Jobs Act, this deduction is capped at $10,000 annually for state and local taxes combined, including property taxes. This cap remains in effect for the 2024 tax year.
Additionally, homeowners may deduct points paid at closing to lower their mortgage interest rate. Points can generally be deducted in the year they are paid if they meet IRS criteria.
Homeowners investing in energy-efficient upgrades may qualify for the Residential Clean Energy Credit. For 2024, this credit allows homeowners to deduct 30% of the cost of installing solar panels, wind turbines, or similar clean energy systems. Other home improvements that increase your home’s basis, like a new room addition or remodeling, can help reduce capital gains taxes when you sell your home.
Finally, the student loan interest deduction, which allows borrowers to deduct up to $2,500 in interest paid, remains available in 2024 for eligible taxpayers meeting income thresholds.
Small Business Tax Deductions: Common Expenses Eligible for Deduction
These deductions can help to offset the costs of running your business and potentially lower your overall tax liability.
One of the most common deductions for small businesses is the cost of goods sold (COGS) deduction. This deduction allows you to deduct the direct costs of producing or purchasing the goods you sell. This includes the cost of raw materials, labor, and expenses directly related to producing the goods.
Another common deduction for small businesses is the home office deduction for the use of your home.
Small businesses may also claim deductions for vehicle expenses, such as gas, repairs, and insurance. Suppose you use your vehicle for both business and personal use. In that case, you’ll need to calculate the percentage of time the vehicle is used for business and only deduct that percentage of the expenses.
Small businesses may also be eligible to claim deductions for travel expenses, such as lodging and transportation. The only requirement is that it is for business purposes. Business meals and entertainment expenses are also deductible, but only up to 50% of the cost is deductible under new tax laws.
Other common deductions for small businesses include employee salaries and benefits, rent, and office supplies.
Saving on Taxes with Retirement Plan Contributions: IRAs, 401(k)s, and More.
Saving for retirement is not only important for financial security, but it can also be a great way to save on taxes at tax time. Individual Retirement Accounts (IRAs) are one of the most popular retirement savings plans. Withdrawals from a traditional IRA in retirement are taxed as income. On the other hand, contributions to a Roth IRA are not tax-deductible.
401(k) plans are another popular type of retirement savings plan. An employer sponsors these plans, and employees can make contributions through payroll deductions. Contributions to a 401(k) plan are made pre-tax, which means that the money is not taxed in the year it is contributed at the federal level. The money in a 401(k) plan also
In addition to traditional and Roth IRAs and 401(k) plans, there are other types of retirement plans that offer tax benefits, such as Simplified Employee Pension (SEP) plans, SARSEP plans, and Simple IRA and Profit-Sharing plans.
State and Local Tax Deductions: How They Affect Your Federal Tax Return
State and local taxes, also known as SALT taxes, can impact your federal tax return. The federal tax code allows deductions for certain state and local taxes, potentially reducing federal taxable income.
The most common SALT deductions include state and local income taxes and property taxes. Taxpayers may also choose to deduct state and local sales taxes instead of income taxes, but not both.
A significant limitation to note is the SALT cap, which limits the deduction to $10,000 for single filers and married couples filing jointly (or $5,000 for married individuals filing separately). This cap remains unchanged for the 2024 tax year, regardless of the actual amount of state and local taxes paid. These deductions can provide savings but may be limited depending on your location and tax circumstances.
Conclusion
Tax deductions and tax credits can save you money when filing your small business tax return. A tax deduction reduces your taxable income while you owe. Both deductions and credits can lower your overall tax bill, but credits are generally more valuable because they directly reduce the amount of taxes you owe, dollar-for-dollar. Examples of deductions include expenses related to your job or business, mortgage interest, and charitable donations. Examples of credits include the child tax credit and the earned income tax credit.
FAQs
What is the difference between tax deductions and tax credits?
Tax deductions and tax credits are both ways to reduce your tax liability, but they work in different ways. The tax deductions lower your taxable income, reducing the amount of income that is subject to tax. Tax credits, on the other hand, directly reduce the amount of tax you owe.
What are some common tax deductions that individuals can claim on their taxes?
Some common tax deductions that individuals can claim on their taxes include mortgage interest, student loan interest, medical expenses, charitable contributions, and state and local tax deductions. These deductions can help reduce your taxable income and potentially lower your tax liability.
Can I claim both tax deductions and tax credits on my taxes?
Yes, you can claim both tax deductions and tax credits on your taxes. Tax deductions reduce your taxable income, while tax credits directly reduce the amount of tax you owe. By taking advantage of both deductions and credits, you can maximize your tax savings and potentially receive a larger refund.
What documentation do I need to provide when claiming a tax deduction or tax credit?
When claiming a tax deduction or credit, you will typically need to provide supporting documentation such as receipts, invoices, and financial statements. It’s important to keep accurate records and retain these documents in case of an audit or if the tax authorities require further verification.
