3.2 Deductions and credits

Deductions and credits are powerful tools for reducing your tax bill. They work differently but both aim to lower what you owe. Deductions shrink your taxable income, while credits directly cut your tax liability dollar-for-dollar.

Understanding these tax-saving strategies is crucial for smart financial planning. From mortgage interest to child care expenses, knowing which deductions and credits apply to you can lead to significant savings come tax time.

Deductions: Purpose and Types

Function and Categories of Deductions

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• Deductions reduce taxable income lowering the amount of tax owed by individuals and businesses
• Two main types of deductions serve different purposes
  • Standard deduction reduces taxable income by a fixed amount
    • Varies based on filing status (single, married filing jointly, etc.)
    • Adjusted annually for inflation ($13,850 for single filers in 2023)
  • Itemized deductions allow taxpayers to list specific expenses
    • Potentially result in a larger deduction than the standard deduction
    • Include expenses like mortgage interest, charitable donations, and medical costs
• Business deductions subtract expenses from business income to determine taxable business profit
  • Examples include office rent, employee salaries, and equipment purchases
• Personal deductions encompass various non-business expenses
  • Subject to certain limitations and phase-outs based on income levels
  • Examples include state and local taxes (capped at $10,000) and student loan interest

Choosing Between Standard and Itemized Deductions

• Taxpayers select the method resulting in the lower tax liability
• Standard deduction offers simplicity and requires no record-keeping
• Itemized deductions potentially provide larger tax savings for some taxpayers
  • Beneficial for those with significant deductible expenses
  • Requires detailed record-keeping and documentation
• Factors influencing the choice
  • Home ownership (mortgage interest deduction)
  • State and local tax burden
  • Charitable giving habits
  • Medical expenses exceeding 7.5% of adjusted gross income

Above-the-Line vs Below-the-Line Deductions

Characteristics and Impact of Above-the-Line Deductions

• Subtracted from gross income to calculate adjusted gross income (AGI)
• Available to all taxpayers regardless of itemization choice
• Reduce AGI used as a benchmark for many other tax provisions and benefits
• Examples of above-the-line deductions
  • Student loan interest (up to $2,500 annually)
  • Alimony payments (for divorces finalized before 2019)
  • Contributions to certain retirement accounts (traditional IRAs, SEP IRAs)
  • Self-employed health insurance premiums
• Advantages of above-the-line deductions
  • Lower AGI potentially qualifies taxpayers for additional credits or deductions
  • May reduce exposure to the alternative minimum tax (AMT)
  • Can increase eligibility for need-based financial aid for college students

Nature and Application of Below-the-Line Deductions

• Subtracted from AGI to arrive at taxable income
• Only available to taxpayers who itemize deductions
• Encompass various personal expenses subject to limitations
• Common below-the-line deductions
  • Mortgage interest on primary and secondary residences
  • Charitable contributions (cash and non-cash)
  • State and local taxes (capped at $10,000 since 2018)
  • Medical expenses exceeding 7.5% of AGI
• Considerations for below-the-line deductions
  • Must exceed the standard deduction to be beneficial
  • Subject to phase-outs and limitations based on income levels
  • Require thorough record-keeping and documentation for substantiation

Tax Credits: Concept and Impact

Fundamentals of Tax Credits

• Provide dollar-for-dollar reductions in tax liability
• Offer more direct benefit than deductions which only reduce taxable income
• Two main types of tax credits affect final tax liability differently
  • Refundable credits can reduce tax liability below zero
    • Result in a refund even if taxpayer owes no taxes
    • Examples include Earned Income Tax Credit and Additional Child Tax Credit
  • Nonrefundable credits can only reduce tax liability to zero
    • Do not result in a refund if credit exceeds tax owed
    • Examples include Adoption Credit and Retirement Savings Contributions Credit
• Value of tax credits remains constant regardless of taxpayer's marginal tax rate
  • $1,000 credit reduces tax liability by$1,000 for all taxpayers

Application and Policy Implications of Tax Credits

• Often used as policy tools to incentivize specific behaviors
  • Encourage education (American Opportunity Credit)
  • Promote energy efficiency (Residential Renewable Energy Tax Credit)
  • Support families (Child Tax Credit)
• Provide targeted relief to certain groups of taxpayers
  • Low-income workers (Earned Income Tax Credit)
  • Parents and guardians (Child and Dependent Care Credit)
  • Elderly and disabled (Credit for the Elderly or Disabled)
• Calculation and application of tax credits crucial for determining final tax liability
  • Applied after deductions and exemptions reduce taxable income
  • Order of application matters for multiple credits
  • Some credits require specific forms or worksheets for calculation

Common Deductions and Credits

Frequently Claimed Itemized Deductions

• Mortgage interest deduction allows homeowners to deduct interest paid on mortgage debt
  • Limited to interest on $750,000 of debt for homes purchased after December 15, 2017
• State and local tax (SALT) deduction capped at $10,000 since 2018
  • Includes property taxes, state income taxes, and sales taxes
• Charitable contributions deductible up to 60% of AGI for cash donations
  • Non-cash donations (clothing, household items) generally limited to fair market value
• Medical expenses exceeding 7.5% of AGI deductible
  • Includes costs for doctors, prescriptions, and certain medical equipment

Popular Above-the-Line Deductions

• Traditional IRA contributions deductible up to $6,000 ($7,000 if age 50 or older) in 2023
  • Subject to income limitations for those covered by employer retirement plans
• Student loan interest deductible up to $2,500 annually
  • Phases out for higher-income taxpayers
• Self-employed health insurance premiums fully deductible for self-employed individuals
• Educator expenses allow teachers to deduct up to $300 for classroom supplies

Widely Used Tax Credits

• Earned Income Tax Credit (EITC) benefits low to moderate-income working individuals and families
  • Maximum credit of $7,430 for families with three or more children in 2023
• Child Tax Credit provides up to $2,000 per qualifying child under age 17
  • Partially refundable up to $1,500 per child
• American Opportunity Credit offers up to $2,500 per eligible student for qualified education expenses
  • Available for the first four years of post-secondary education
• Lifetime Learning Credit provides up to $2,000 per tax return for qualified education expenses
  • No limit on the number of years the credit can be claimed
• Foreign Tax Credit prevents double taxation on income earned abroad
  • Allows credit for taxes paid to foreign governments on foreign-source income