All United States taxpayers must file an annual income tax return. Completing your tax return determines your tax liability, or how much you owe in taxes for that year. Your tax liability takes into account your income, any taxes that have already been paid in advance or withheld from your wages, tax deductions or credits that you are eligible to claim, and any other relevant information.
There are three main sections of your tax return:
The income section lists all sources of income (wages, dividends, self-employment income, royalties, rental income, etc.)
Deductions decrease the taxpayer's amount of taxable income.
Credits directly offset the amount of tax owed.
The distinction between tax deductions and tax credits is often misunderstood. So what’s the difference?
Tax credits and tax deductions offset your tax bill in different ways. Tax credits reduce a taxpayer's tax bill dollar for dollar, whereas tax deductions reduce the amount owed by only a percentage of each dollar.
Types of Tax Deductions
There are two main categories of deductions: "above-the-line" deductions and "below-the-line" deductions.
Above-the-line deductions are subtracted from a taxpayer’s gross income to arrive at their adjusted gross income (AGI). Also called adjustments to income, above-the-line deductions are available to everyone who qualifies.
After calculating their AGI, taxpayers can choose between itemizing their deductions or taking the standard deduction. These two options are called below-the-line deductions.
The standard deduction is a specific dollar amount that can be subtracted from an individual's taxable income. A taxpayer's standard deduction amount is determined by their filing status. Certain taxpayers are not eligible for the standard deduction.
Some taxpayers opt instead for itemized deductions. Expenses that may be itemized include the following (subject to limitations):
Out-of-pocket medical and dental expenses
State and local taxes (SALT), subject to a $10,000 limit
Home mortgage points
Home mortgage interest expenses
Most taxpayers opt for the standard deduction, but itemizing your expenses may be a good choice if it would result in a lower amount of taxable income. If you aren’t sure which is the right choice for you, it may be helpful to prepare your tax return both ways before deciding whether to itemize or take the standard deduction.
Types of Tax Credits
Some tax credits are refundable, meaning that if the credit surpasses the amount of tax you owe, you will receive all or part of the excess in the form of a tax refund. Other tax credits are non-refundable; if the credit amount exceeds your tax liability, you will not receive the excess amount as a refund.
In other words, a non-refundable tax credit can reduce your tax bill to zero but no lower, whereas a refundable credit can reduce your tax bill below zero, yielding a refund from the government to cover the difference. This means that even if you don’t owe any taxes or aren’t required to file a tax return for the year, you may still be entitled to a refund.
As you can see, there is a lot to consider when it comes to tax credits and deductions. Be sure to contact your local CPA each tax season to guide you through the filing process and help you minimize your tax bill (or maximize your refund).