Yahoo News Podcast: Credits or deductions? Here are the differences
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Janna Herron: This is Taxes Made Simple by Yahoo Finance and Turbo Tax. I'm Janna Herron.
Tax credits and tax deductions. What's the difference between them? Both a tax credit and a tax deduction are very helpful on your tax returns, helps you to save money, but they do it in different ways. It's important to understand how they do it.
A tax credit is the most beneficial and that's because it's giving you a dollar for dollar reduction of your tax liability. For example, a tax credit that's valued at $2,000, such as the child tax credit, lowers your tax bill by $2,000. That's great.
A tax deduction also lowers your tax bill, but not one for one. It depends on your tax bracket, how much you'll get out of a tax deduction. If you fall into the 12% tax bracket, a $1,000 deduction saves you $120.
There are important differences among tax credits as well. There's a tax credit that is called nonrefundable. What that means is if you don't owe very much in taxes and you get a tax credit, but it takes you below zero on your tax bill, you're not going to get a refund of the difference. For example, say you have an $800 tax bill and you get a $1,000 nonrefundable credit, that doesn't mean that you're going to get $200 back from the government. That's a nonrefundable credit.
But there are some credits that are refundable. That means that if you have that $800 tax bill, you get a $1,000 tax credit and it's refundable, you get $200 back from the government. Some of the most popular refundable credits are the earned income tax credit, also called EITC and the child tax credit.
The IRS has specific requirements for you to qualify for both nonrefundable and refundable credits, so you need to look into that.
Then there are deductions. There several different types of deduction. The big one that you're probably familiar with, as most taxpayers are, is the standard deduction. It's the one-size-fits-all reduction in the amount of your taxable income. You don't really have to do anything to qualify for the standard deduction. You just can take it. For single taxpayers this year, it's $12,200; for those married filing jointly, 24,404; and for heads of household, it's $18,350. You can claim the standard deduction on your regular form 1040, which is the basic tax form that you use.
Other deductions that you might take, you have to itemize your taxes. You don't take the standard deduction in this case. You will be taking all these other smaller deductions that should add up to more than the standard deduction for it to be beneficial for you. There is a deduction for the state and local taxes that you pay. That's capped at $10,000, which is the second year that it's been capped. There is a deduction for the mortgage interest that you pay during the year. There's a deduction for medical expenses. As long as you spent enough on your medical expenses during the year to reach the threshold, then you can deduct some of those costs. Everybody's probably heard of a deduction for charitable donations. That also exists. If you end up itemizing your deductions, it's going to be a little bit more work when it comes to filing your taxes because you have to make sure you have the required documentation for all of those things, such as the mortgage interest. You need to know how much mortgage interest you paid during the year. You have to have documentation that you donated so much to a charity.
For those of you who are self-employed, deductions are probably very important to you. Anything that you spent on your business can be deducted. For example, if you use a room in your house as your office, a certain amount of your heating bill, a certain amount of the mortgage that you pay or rent that you pay, may be deductible. If you have a phone line that's dedicated to your business, also, that cost can be deductible.
Over the years, there've been very interesting deductions that people have taken and that the IRS approved. For example, a Wisconsin bodybuilder deducted almost $14,000 for the cost of body oils, including a tanning product. This was from 1999 to 2001, because it helped his career. The US tax court okayed these business expenses because they were used for his business.
It's really important to make sure that the deductions you make are not exaggerated and that you do have that proof. Anytime deductions that are a little bit higher than they should be will raise the eyebrows at the IRS, especially if you fudge the mortgage interest that you paid or charitable contributions. The IRS will definitely lookout for that. Agency uses statistical algorithms to make sure that your deductions are in line with your income. If they're too high, they may send a letter asking for more documentation. This is especially true when it comes to business expenses. People seem to think that there's a lot of wiggle room when it comes to reporting that. You don't want to claim more deductions than your profits, for example, or writing off 100% of an item as a business expense that is often used personally, such as your cellphone or your car. That also will be a red flag to the IRS. That's all for tax credits and deductions.
This is Taxes Made Simple from Yahoo Finance and Turbo Tax. Please head over to Apple Podcasts and leave a five-star rating and review there. Until next time, thanks for listening.
