Nobody likes the idea of paying more income tax than they need to, and understanding the various options for reducing your tax bill can save you a significant amount of money every year. By using tax credits, deductions, and adjustments correctly, you can seriously reduce the amount you turn over to the IRS.
The problem is that there is a lot of confusion when talking about these tax “write-offs”. While all three usually result in a lower tax bill, not all write-offs are created equal.
What are tax credits?
Unlike a deduction or adjustment, which serves to reduce your taxable income, a loan directly reduces the amount you owe in taxes. Since tax credits are responsible for this massive reduction in your tax bill, they provide the most benefit when it comes to how much you pay in taxes.
If you’re a parent, you’re probably already familiar with tax credits due to the popularity of the Child Tax Credit and the Child and Dependent Care Credit. Governments also offer tax incentives to encourage certain behaviors, such as replacing old appliances with new, energy-efficient models.
Why are tax breaks important?
Tax credits are the best way to reduce your tax liability. When you qualify for a tax credit, you get an exact dollar-for-dollar reduction in the amount you owe.
For example, if you owe $3,000 in federal taxes, a matching $2,000 credit will bring your tax bill down to $1,000, leaving more money in your pocket.
There are three different types of tax credits:
- Non-refundable tax credits deducted from your tax bill until the amount you owe is zero. This means that if you owe $4,000 in taxes and receive a $4,500 tax credit, you end up owing $0 in taxes, but you cannot withhold the additional $500 from the credit.
- Reimbursable tax credits are fully reimbursable and provide the maximum benefit, because no matter what you owe, you get the full amount of the loan. For example, if your tax bill is $4,000 and you received a $4,500 tax credit, you end up owing $0, plus you will also be paid an additional $500.
- Partially refundable tax credits fall somewhere in between: 40% of the partially refundable tax credit is refundable and the remaining 60% is non-refundable. For example, the $2,500 US tax credit is partially refundable, so up to $1,000 of that amount can be paid to you even if your tax bill has already been reduced to $0.
How to determine tax deductions
Once you understand the three different types of tax breaks, you can begin to figure out which ones are best for you. The IRS website has an extensive list of tax credits for individuals classified by family size, whether you are a homeowner, how much you paid for health care or education expenses, etc.
Some tax incentives you may already be familiar with include:
- Earned income tax credit
- Home loan for the poor
- Credit for the care of children and dependents
- American Tax Credit for Opportunity
- Education loan
Your best bet is to work with a tax professional to determine if you qualify for these and other loans offered by the government. Or you can use tax software like Turbo Tax, H&R Block or Cash App.
What are deductions?
When people talk about tax write-offs, they usually mean deductions. As a shorthand way of saying itemized deductions, which are also known as under-the-line deductions, tax deductions reduce your tax bill but don’t match dollar for dollar like a tax credit does.
Instead, the deductions reduce the amount of your taxable income. Depending on which tax bracket you are in, you can save more or less on the deduction than someone with a higher or lower income.
To determine the effect of the deduction on your debt, you multiply the amount of your deduction by your tax bracket. For example, if you have a $6,000 deduction and are in the 10 percent tax bracket, you will pay $600 less in taxes.
Read more: Tax brackets (marginal tax rates)
Why deductions are important
A deduction designed to offset your tax arrears applies when you pay for expenses such as tuition, health care, pension contributions, and any self-employment income or loss you make during the tax year.
Before you collect all your receipts, know that you should only use these types of itemized deductions if your total deduction is greater than the standard deduction you receive automatically. For tax year 2022, the standard deduction is $12,950 for individuals.
How to determine deductions
The most common tax deduction is the amount of interest you pay on a mortgage. As mentioned earlier, deductions do not reduce your tax bill on a dollar-for-dollar basis, but they do reduce your taxable income, which in turn reduces the amount you owe.
As a rule, deductions do not provide tax benefits, unless you spend huge amounts on related expenses. They are only beneficial if your expenses are in excess of the standard deduction amount, which is not common for most.
What are adjustments?
Adjustments are another category of tax write-offs that reduce your overall or gross income. Although they are used to reduce your overall tax liability, you do not go through the complicated and time-consuming process of listing them. Instead, the adjustments are directly deducted from your gross income and used to get your adjusted gross income (AGI).
Why are they important
Your AGI is an important factor, perhaps even more important than your taxable income, as it determines the various deductions and credits you are eligible for. Understanding how adjustments affect your income helps reduce the amount of taxable income you report on your tax return.
The more adjustments are deducted from your income, the lower your AGI becomes. Although the adjustments do not directly affect the amount of taxes you owe, they do change your AGI. Since this is what is used to determine your tax bracket and the percentage of income tax you pay, a lower AGI means a lower tax bill.
How to spot adjustments
It may surprise you that the standard “student loan interest deduction” is a tax adjustment and not a deduction at all. The amount you pay as student loan interest is used to adjust your gross income to get your AGI.
Other general adjustments include:
- IRA contributions
- If you are self-employed, half of the self-employment taxes you pay
Read more: What to Choose: Roth IRA or Traditional IRA?
Summary
When calculating the amount you owe in taxes, keep in mind that there are significant differences between deductions, credits, and adjustments. If you take the time to understand these differences and how they interact with each other, you will significantly reduce your overall tax bill.
If you are overwhelmed by all this information, your best bet is to use a tax program or tax software that can help determine your loans, deductions, and adjustments for you.
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