Understanding how tax deductions and credits work, how they effect to your filing status and yearly expenses, and what receipts you should be keeping throughout the year will help you hold on to more of your money come tax season.
Tax Deductions
Tax deductions lower your taxable income based on your marginal tax bracket. Broken down into simple numbers and terms, that means if you’re in the 22 percent tax bracket, a $1,000 tax deduction saves you $220 you don’t have to pay in income tax (0.22 x $1,000 = $220). Think of it as reducing the amount you are taxed on.
There are two main types of tax deductions: standard deductions and itemized deductions. You can only use one of these deductions when filing. The good news is, you get to choose whichever type of deduction saves you the most money.
Standard deductions are set before the start of each year, and while the amount of each deduction usually changes, the categories do not. The categories of standard deductions and their 2018 tax year amounts are: single filing status, $12,000; married filing together and surviving spouse, $24,000; married but filing separately, $12,000; and head of household, $18,000.
Itemized deductions are used when their total exceeds the standard deduction of a taxpayer’s filing status. Qualified expenses include medical expenses, property taxes, charitable donations, mortgage interest, and others. Some itemized deductions are based on a “floor” amount, or minimum, so you can only deduct the amount if it exceeds the specified floor.
If you decide to itemize your tax deductions, it’s important to keep detailed records of those expenses throughout the year to ensure you maximize your deduction and to ensure you don’t miscalculate and chose itemization over taking the standard deduction.
When considering whether to use standard or itemized deduction, you should know there is an income limit for those who itemize their deductions.
Tax Credits
Where tax deductions reduce what taxpayers owe by decreasing the amount they are taxed on, tax credits are a dollar-for-dollar reduction of their income tax liability, the amount they owe in taxes. So, a $1,200 tax credit saves you $1,200 in taxes owed. Tax credits depend on several factors, including taxpayer income, age, filing status, and other qualifications.
There are fewer tax credits than tax deductions. They are available for things like adopting a child, child care expenses, buying a first home, home office expenses, and caring for elderly parents. There are also business tax credits to consider. It’s important to know that most tax credits are non-refundable and expire in the year they were used, so the additional amount is not paid back to you in your tax refund.
In the end, tax credits are worth more than a dollar-equivalent tax deduction; e.g., for that taxpayer in the 22 percent tax bracket, a $1,000 credit is $780 more in savings than a $1,000 deduction, which only saves them $220. Both tax credits and deductions can help you pay less in taxes, so consult a tax professional or software to ensure you’re claiming the most deductions and credits.