As you prepare to file your income tax return, you’ll probably run across the terms tax deduction and tax credit. Both individuals and businesses can take advantage of tax deductions and credits to lower their income tax and possibly increase their refund. In today’s blog from LongSchaefer, our tax planning experts take a look at the differences between tax credits and tax deductions.
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Reducing Income Versus Reducing Taxes You Pay
The major difference between a tax deduction and a tax credit is that deductions lower the income on which the government bases its tax calculations, while tax credits directly reduce the amount of tax you owe.
For example, you get to take a tax deduction of $18,650 because you’re the head of a household. If you made $50,000 in that year, the head of household deduction lowers the amount of your gross income to $31,350. Rather than pay 15% of your income at $50,000, you pay 15% of $31,350. You would pay $4,702.50 rather than $7,500 for taxes in this simplified example.
After you calculate how much money you owe in taxes, a tax credit can lower the amount of tax you pay (or even lead to a higher income tax return). For instance, your tax bill comes to $700. However, you qualify for two tax credits. One is refundable for $500, and one is non-refundable for $750. The $750 credit reduces the amount of tax you owe to $0, while the refundable tax credit means you receive $500 from the IRS.
Deferring income to retirement also has tax benefits for you before you retire. The IRS allows an annual $19,500 elective deferral to 401(k) plans. When you reach age 50, that maximum amount increases to $26,000. You don’t pay income taxes on that pre-tax deduction when you’re working because you’ll pay income taxes after you retire.
Tax planning services can point you to the right types of tax credits or tax deductions available to you.
Examples of Tax Credits
The most common tax credit for individuals is the Child Tax Credit from the Internal Revenue Service. In general, your child must be 16 years old or younger and meet certain qualifications. Each individual can earn up to $2,000 per qualifying child, and up to $1,400 of that is refundable, meaning you can get money back from the IRS.
There’s also the Earned Income Tax Credit for working people with low to moderate incomes who have children. The EITC is in addition to the Child Tax Credit.
Business owners can take advantage of tax credits, too. Small employers can take the General Business Credit for undertaking certain activities, such as investing in electric vehicles, increasing research activities, retaining employees, and having employer differential wage payments. Tax planning staff at LongSchaefer will show you what tax credits you may be eligible for.
A refundable credit means you could get that money back from the IRS. A non-refundable credit simply lowers the amount of taxes you may owe, all the way down to zero.
Examples of Tax Deductions
Tax deductions work differently for individuals and businesses. Individuals can take a standard deduction based on your filing status (single, head of household, or married filing jointly).
Individuals may choose to deduct certain health care expenses, interest paid on mortgages, and charitable donations. There is one caveat: You can itemize your deductions for federal income taxes, but they must be more than your standard deduction.
You can deduct certain business expenses from your income to lower your income. Let’s say your business earned $200,000 in 2020. But you invested in new equipment that cost $25,000, advertising for $5,000, and computer software at $3,000. All of these items could lower your income to $167,000. At 25%, you would pay $41,750 in income taxes rather than $50,000 in this simplified example.
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Tax Planning From LongSchaefer
The tax planning pros at LongSchaefer can help you get the most out of your income taxes, whether you’re a business or an individual. Contact us online or call (513) 245-0300 for more information on how our firm can help.