Credits and Deductions

Let’s talk a little bit about tax credits and tax deductions. Both can be used to help reduce or avoid taxation but behave differently when it comes to doing so.

Tax deductions are beneficial because help lower the amount of your income subject to taxation. Deductions may be either “above the line” or for AGI, or “below the line” or from AGI. The line in the sand in this scenario is of course, AGI (adjusted gross income).

Above the line deductions are beneficial because they reduce gross income to arrive at AGI. A lower AGI may result in being able to take advantages of other benefits in the Internal Revenue Code (IRC) such as being able to contribute to a Roth IRA and qualifying for additional tax credits (discussed below).

Common above the line deductions include pre-tax 401(k) contributions, student loan interest, deductible contributions to a traditional IRA, HSA contributions, and self-employed business expenses (Schedule C).

Once AGI is reached, below the line deductions can be applied. Below the line deductions lower AGI further, to arrive at taxable income. Below the line deductions are going to come from either itemized deductions (Schedule A) or the standard deduction – a deduction everyone qualifies for and varies in amount based on filing status. You may either itemize or take the standard deduction, but you cannot do both.

If you itemize, you’ll use Schedule A. Common deductions on Schedule A include medical and dental expenses, home mortgage interest, state and local taxes, and charitable contributions. Some deductions on Schedule A (such as medical and dental) are subject to a floor of AGI. An AGI floor means that the expenses may be deducted once they’re higher than the floor. For example, if your AGI is $100,000 and the deduction has a floor of 10%, then any expenses above $10,000 would be deductible.

Once all deductions have been taken, you arrive at your taxable income. It’s here where the applicable tax rates are applied, and your tax is calculated. However, you may still benefit from tax credits.

Tax credits reduce the amount of tax owed on a dollar-for-dollar basis. Whereas deductions reduce taxable income, credits lower the amount of taxed owed. For example, if you owe $2,000 in taxes but have $1,500 worth of credits, then your net taxed owed would be $500. In some instances, your tax credits may eliminate any taxes owed. In fact, you may even qualify for a refund based on your credits exceeding the tax you owe (called refundable or partially refundable credits).

Naturally, the specific credit(s) you may qualify for depends on your situation. For example, parents can take advantage of the child tax credit, American opportunity tax credit, child and dependent care credit, and the earned income tax credit. Other credits you may be eligible for are the lifetime learning credit, saver’s credit, adoption credit, and residential energy credit.

To see what credits and deductions make the most sense for your situation, talk to a tax professional such as a CPA that specializes in taxes, an EA, or tax attorney. You don’t want to leave money on the table or pay more tax than required.