The U.S. Tax Code provides tax relief under various conditions in the form of tax deductions and tax credits. While both of these can save you money, they work very differently. Additionally, there are business tax deductions which are not covered here.
In order to understand how tax deductions and credits operate, it is necessary to provide some basic taxation definitions. A person’s gross Income is “all income from whatever source”. Adjusted gross income (AGI) is gross income minus certain adjustments to income like deductible IRA contributions. AGI is reported on Line 4 of the Form 1040EZ, line 21 of the Form 1040A, and Line 37 of the Form 1040. Most deductions, however, are based on something called modified adjusted gross income or MAGI, which is generally AGI plus many of the adjustments from gross income used to calculate AGI. So MAGI typically falls somewhere between gross income and adjusted gross income.
Our federal tax system operates using graduated or marginal tax rates. As your income increases, the rate at which your income is taxed increases as well. For example, in 2016 the lowest tax rate is 10% for a single filer’s AGI below $9,276, while the maximum rate is 39.6% for single filers whose income is $415,050 or more. There are five other marginal rates in between. AGI cutoffs also vary based upon filing status. Those who file married filing joint returns normally have higher AGI cutoffs.
Varying Levels of Relief
Tax deductions provide varying levels of relief based upon this marginal tax bracket. Normally, the higher your tax bracket, the higher your tax savings from a deduction. So, if you qualify for a $1,000 tax deduction, then the tax savings from that deduction would be $280 for a taxpayer in the 28% marginal tax bracket ($1,000 times 28%). Keep in mind that deductions can be limited or even completely eliminated at higher income levels through something called a phase out. For example, up to $2,500 of qualified student loan interest may be deducted from income as long as your modified adjusted gross income is less than $80,000 (single filer). If you are fortunate enough to make at least $80,000, then you are unfortunate enough to not be able to deduct some or all of this interest expense.
Common tax deductions include interest paid on your primary residential mortgage (including any points paid to finance or refinance the home), interest paid on a second home, state sales taxes paid, charitable contributions, student loan interest, job search expenses, moving expenses for your first job, and military reservists’ travel expenses.
Tax Credits: Dollar-for-Dollar Reductions
Tax credits are much simpler to understand; they are a dollar-for-dollar reduction in taxes owed. While phase-outs typically apply, tax credits are not based on your marginal rate. So, if you qualify for a $1,000 tax credit, then the tax savings from that credit would be $1,000. Most credits are “nonrefundable,” which means that they can reduce total taxes owed to $0, but they cannot create a tax refund when you would not have already qualified for one. Some tax credits are “refundable” meaning that they can reduce your taxes owed to $0 and provide a tax refund on the balance of the credit. For example, the American Opportunity Credit, which is a tax credit for expenses relating to the first four years post-secondary education, provides a credit up to $2,500 for taxpayers whose MAGI is $80,000 or less (single filer). 100% of the first $2,000 of qualified education expenses paid and 25% of the next $2,000 expenses paid qualify for the credit. But this credit is partially refundable. If the credit pays your tax down to zero, you qualify to have 40% of the remaining amount of the credit (up to $1,000) refunded to you.
Other tax credits include the Child Care Credit, Earned Income Credit, Lifetime Learning Credit, and credits for improving your home with energy saving devices. And remember, as you’re checking to see if you qualify for these credits, it’s good to check your personal credit as well. You can learn how taxes affect your credit score, how to check your annual credit reports and also view your credit scores for free each month on Credit.com.
It is very important to understand that each of these deductions and credits require that you understand the limitations and rules governing their use. You should seek the guidance of a tax professional to make certain that you qualify and that you are applying them correctly.
More on Income Tax:
- How to File Your Taxes for Free
- How to Maximize Your Tax Refund
- Do Unpaid Taxes Affect Your Credit Report?