Tax credits and deductions ensure that your bill is lower than it otherwise would have been. But they do so in different ways: while credits reduce tax dollar for dollar, deductions reduce your taxable income – and thus what you owe – by the amount of the deductions multiplied by your tax rate.
To build a strong, tax efficient strategy, it’s important to understand how these 2 tools work. At Thrivent Financial Advisors, we serve clients year round so you can continue to reach your maximum potential.
Deductions
An individual tax credit reduces your tax liability directly; deductions, on the other hand, reduce taxable income and are worth less in high tax brackets than in low brackets.
Deductions provide an offset against certain expenses you incur – mortgage interest or business expenses, for example – but if they don’t happen to fall into your lap, then no relief there either; some of them benefit only spendaholics or responsibility-bearers, and might favour homebuyers over renters.
Second, deductions exacerbate inequality by increasing tax complexity and distorting market incentives. Mortgage-interest deductions, in particular, incentivise people to buy houses they would otherwise not buy (which ends up further enriching the already rich), rather than replacing their spending on other goods with what they spend on mortgage interest.
Credits both encourage beneficial behaviours and promote welfare (eg, the earnings-related income tax credit aids families with little or no taxable income by reducing the amount they owe in taxes and promoting spending, which, in theory, promotes economic growth), while also recognising our strain on the healthcare system and honing and rewarding entrepreneurship and innovation.
Lastly, some tax credits are refundable; that is, they can lead to a tax refund that’s greater than the total amount of taxes paid during the year. Refundable credits help to make the tax system more equitable and fair.
Tax experts agree that any legitimate deduction or credit helps to reduce your tax bill, although tax credits are more direct. A credit reduces a filer’s tax liability dollar for dollar, whereas a deduction acts on taxable income, lowering tax rates but not the amount due. Knowing how a credit is different from a deduction is crucial. It can sometimes be the difference between a tax-time papal blessing and a humbling scene from The Sopranos. Fortunately, the IRS offers many educational resources to help you build your tax literacy in preparation for tax season.
Credits
Most financial experts consider credits preferable to deductions in lowering your tax liability. That’s because credits reduce what you owe the government, while deductions reduce merely what you report to the IRS – before actually being taxed – on your Form 1040. How many dollars? The amount of a deduction varies according to your tax bracket; the amount of a credit is a function of liabilities owed.
Some tax credits are refundable: this means that, if they are greater than your total tax liability, you can get a refund. The American Opportunity Tax Credit for families to help with higher education expenses, for example, can be as much as $1,000; if that value has larger value beyond your tax liability, then up to $1,000 of it will be refundable. Others include the Earned Income Tax Credit and Child Tax Credit.
Like deductions, some credits and deductions can change with laws that alter the tax code; check with a tax professional or with the IRS.
All these deductions help to lower your employees’ tax bill while also helping your tax strategy as a business. Tax professionals help smooth the path and navigate the deductions eligible for you. Working with a pro may also help uncover tax strategies more customised to your unique situation. Like getting more bang for your buck on taxes, your deductions can help your employees eat healthier by setting up a reimbursement to employee purchases through a cafeteria plan. Deductions can also work to improve employee wellness by encouraging the use of public transport with a commuter café programme that reimburses employee costs of public transport for commuting. And how better to make a city greener than helping employees not driving to work (plus healthier)? For more information on these and other amazing deductions eligible to your business, talk to your accountant or go directly to the source by visiting the IRS website. The information in this communication has been prepared by TCG for informational purposes only and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.
