Tax Credits and Deductions are probably the most exciting part when preparing your tax return. They both help you save money by reducing your overall income tax liability. So, you should take a full advantage of all the tax credits and deductions you qualify for.
As many still get confused about the difference between tax credits and tax deductions, here’s a simple introduction to the these two in the light of the New Tax Reform that just has been approved.
First things, first. The most distinctive difference between the tax credits and the tax deduction is the way they lower your tax liability:
- The tax credits reduce your bill dollar-for-dollar, which means that a $100 tax credit will lower your tax bill by $100.
- Tax deductions lower your taxable income, which is the base to calculate your tax liability. The lower the taxable income, the lower the tax owing.
So far, so good? Let’s take a closer look at these might be the only bundles of joy on your tax return!
The tax credits always result in higher reductions of your tax liability, and sometimes they can reduce your tax owing below zero. Remember, tax credits are applied one you calculate your tax liability for the year. If you have a tax liability of $600 and you apply for a $1,000 tax credit, you won’t have any tax payable, but the remaining $400 of the tax credit WILL NOT be refunded.
That is a case for more of the tax credits as the majority of them are non-refundable. The additional child tax credit is one of the very few refundable tax credits, thus even if your tax owing is zero, you might still claim the credit and the IRS will send you a check for $1,000. Pretty sweet, eh? Better mark that one when you have a child and prepare your own tax return.
The IRS offers a wide array of tax credits, however, they do not suit everyone. You need to know what type of credits are available to your situation. Depending on your filing status, age, employment, education etc. various limitations might apply.
On the top of that, you need to be aware how certain tax treatments, deductions and exemptions correlate with each other, as you might find that claiming one, might disallow you to claim another. That might be the reason over 70% seek professional help going through this maze. Even the IRS advises consulting a professional if you’re unsure about the credits you are planning to claim.
Tax credits are generally less common and less known than tax deductions. Many of our clients didn’t know about the credits they could claim and there are plenty! Adopting a child, buying a first home, child care expenses, home office and various business tax credits are just some of them.
Let’s move on to the tax deductions!
Tax deductions lower your taxable income and there are two main types of deductions: the standard deduction and itemized deductions. Most of the taxpayers choose the standard deduction, however, if your itemized deductions are greater than the standard deduction, you should by all means itemize.
While standard deduction is fixed and depends on your filing status, the itemized deduction allows claiming a greater deduction – given the total amount of qualifies deductible expenses is higher than the standard deduction. Of course, these are subject to various limitations depending on the type of expenses and some of them are based on a minimum amount and you can only deduct the expenses that exceed this amount.
Most of the new changes to the tax code under the new bill won’t affect us until 2018, meaning the return we’ll file in 2019. However, the IRS already announced some changes that will already be present while filing the 2017 tax return. One of the biggest changes affect the itemized deductions and will even enhance the deduction for some medical expenses. The minimum amount of 10% of your adjusted gross income dropped to 7.5%, which means you can deduct more of your medical expenses this year!
To itemize your deductions, you need to complete form Schedule A. You can only file the Schedule A with 1040 (1040A and 1040EZ disallow itemized deductions). It is also important that you keep all records of those itemized deductions in case the IRS asks for them.
Another thing to remember is, there is an income limit for taxpayers who itemize their expenses and if your adjusted gross income exceeds this limits, you might not be able to claim all your itemized deductions. Over a certain level, you might not be permitted to itemize at all.
What is better?
Tax credit and tax deductions are different and vary depending on your situation. There’s no better or worse for this matter. Both offer various benefits if you qualify. Note, that you need to qualify for the credits or deductions before claiming them on your tax return. Misinformation might trigger IRS audit and there is a potential risk of penalties, thus make sure you know what you’re claiming. Consult a professional if necessary.