For this friendly tax installment, we are going to reverse course from being in the tax weeds and bring it back to things that are basic. This installment is going to cover Tax Deductions and Tax Credits, what the difference is, and how they work.
I’m sure you have heard of a tax “write off”
Maybe you have a friend that offers to pay for meals and says, “I can just write it off” or something to that effect. What does that even mean? Can you invite me to these lunches?
A more technical term for a tax write off is a tax deduction. All right, got it. Tax Deduction = Tax write off. Now what?
Tax deductions are generally quite broad and cover a wide array of expenses given your specific set of tax circumstances. First we will start with how your tax is determined. Calculating tax starts with your income – the amount of money you earn, not necessarily the cash that hits your account. Once you have your income tabulated, you subtract or “deduct” expenses that are allowed under our tax laws to reduce your income. This is sometimes referred to as net income or taxable income. Your tax is then calculated based on your taxable income. So deductions reduce the amount of income that you are required to pay tax on.
Some common deductions for most individuals who are employees might be retirement plan contributions, HSA account contributions, student loan interest, or itemized deductions. Many individuals take advantage of the increased “standard deduction” rather than itemize those deductions. Taxpayers who own a business are permitted to deduct from their gross business income a much broader range of expenses – travel, payroll, advertising, and other expenses deemed to be necessary trade or business expenses.
Great, so if I can deduct it, that means the government is paying for it right, by reducing my tax, right?
Going back to the above, your deductions reduce the income used for calculating your tax not your actual tax directly. If you spend $3,000 as a deduction, that does not translate to $3,000 in less tax. You have to look at your tax rate. If you are in the 20% marginal tax bracket, then that deduction would save you $600 in tax ($3,000 x .2). If you are in a higher bracket, then your deduction will reduce your tax more. You can think of deductions as buying things at a discount that is variable from taxpayer to taxpayer based on your tax bracket. You still have to spend the money, you just save some in tax later when you file your return.
So what are tax credits then? Is that even a real thing?
Tax credits actually directly reduce your tax owed instead of the income on which your tax is calculated. They are factored in after the tax is calculated and reduce it dollar for dollar. You may be thinking “Well that sounds way better, lets just do that instead”.
That’s because it is better, but tax credits are limited by the government on purpose for this reason. You have to be eligible to qualify for them, and they are limited to specific circumstances. For example some prominent credits for individuals are the child tax credit, the earned income credit, the dependent care credit, and the American Opportunity tax credit. Each of theses credit will reduce your tax directly by the amount of the credit. Most of them have income limitations and/or other qualifications so that the credit is limited to the targeted groups. However, definitely take legal advantage of them if you can.
Business owners have other credits available to them as well on a host of things. The research and developmental expenditures credit is a big one meant to incentivize businesses to engage in new technology development or processes. In recent years, many environmental based credits have been opened up for both businesses and individuals to encourage investments in technologies or products deemed good for the environment.
One credit that has been in the news lately is the Employee Retention Credit. While in theory it was a great credit for business owners to retain employees throughout the pandemic, it was so throughly abused by fraudsters that the IRS shut the credit down and stopped processing new claims.
So, now you know the difference between tax credits and tax deductions. Tax credits are in effect much better but on the down side, much more limited in applicability. While tax deductions don’t reduce tax by the same degree as a credit, they are so much broader in availability that they can not be neglected.
I hope this helps the next time you are chatting with you friends about taxes (everyone does this right?) You will be able to throughly the discuss the merits of writing off that Starbucks Latte or new iPad.
As always, if you have specific questions about expenses that could be deductible or credits of which you could take partake, consult a qualified tax professional. This is a blog, not tax advice.