Most people know of and apply common tax deductions such as Home Mortgage Interest & Charitable Donations. However, there are items that can have a greater impact on reducing your tax burden, known as Tax Credits. We wanted to define both and provide some great resources when trying to reduce your taxes.
Tax Deductions are applied to your taxable income. For example, a tax deduction of $5,000 would reduce a person’s taxable income from $60,000 to $55,000. At a 25% tax rate, the total dollars saved would be $1,250 (25% X $5,000).
Common Tax Deductions include:
- Home Mortgage Interest
- Property Tax
- Charitable Contributions
- State, local and foreign income tax, property tax paid
- Medical and Dental Expenses
A larger list of Deductions can be found by HERE.
Tax Credits are much better as they are applied dollar-for-dollar on the amount of taxes you owe. In our example above, the tax deduction provided a savings of $1,250. A tax credit of $5,000 would result in a savings of the full $5,000.
So, a Tax Deduction of $5,000 puts $1,250 into your pocket whereas a Tax Credit puts the entire $5,000 into your pocket.
Two Forms of Tax Credits: Refundable and Non-refundable.
Refundable Tax Credits
If the amount of income tax you owe is less than the tax credit(s) being applied, you pay zero taxes AND get a refund for the remaining balance! For example, if you owed $1,500 in taxes but had $2,000 in refundable credits, the IRS will send you a check for $500!
Common refundable tax credits include:
Non-refundable Tax Credits
If the amount of income tax you owe is less than the tax credit(s) being applied, you pay zero in taxes and would NOT receive a refund for the remaining balance.
In our example, you owed $1,500 in taxes but had $2,000 in refundable credits, you would not owe any taxes, but the IRS would not send you a check for the remaining $500. That would be forfeited.
Non-refundable tax credits are more common. Here are some examples:
- Child Tax Credit
- Child & Dependent Care Credit
- American Opportunity Tax Credit
- Lifetime Learning Credit
- Retirement Savings Contributions
- Residential Energy Efficiency Credits
As you can see, tax credits are typically better than deductions.
We have created a cheat sheet of the Top 61 Tax credits currently available in the U.S. Now you can be armed with a list of possibilities when meeting with your tax adviser. Bring this list to them and see what you qualify for – or could qualify for if you change your situation or investment strategy.
Since the tax law changes frequently, you need to work with your tax professional when applying these deductions and credits.