What’s the difference between a tax deduction and a tax credit—and which should you take advantage of when you file your taxes? Tyler Dolan, CFP®, explains everything you need to know.
Who’s your best friend during tax time? Is it your CPA? Is it your online tax prep service? Or is it your glass of wine as you gather your documents to slog through the online tax service’s questionnaire? (Mine would be a pinot noir.)
Whether you DIY or have a CPA, you may be adding tax deductions and credits to your list of BFFs by the end of tax season. They work a bit differently, but they can each end up reducing the amount of money you owe to Uncle Sam or increasing your refund.
How are Tax Credits Different from Deductions?
My last post in this tax series was about itemizing deductions vs. the standard deduction. I walked through a simplified version of the federal tax calculation, and used an example to show how deductions don’t equate to a dollar-for-dollar difference in tax liability. (For example, a $100 deduction doesn’t equate to saving $100 in tax liability. You only see a certain percentage of the tax break.)
Tax credits, on the other hand, do make a dollar-for-dollar difference in tax liability. In other words, a $100 tax credit can reduce an owed amount by $100 or can increase your refund by $100. This is because the tax credits section of the Form 1040 (the most commonly used form to file federal tax returns) is considered after your federal tax is calculated.
So if the IRS called you one day and offered you a $100 tax break, but you have to choose between a deduction or a credit, which one should you choose? The credit, 100 percent of the time. (Let me know if that ever happens to you. I want in!)
Lucky for you, online tax programs are better than ever at recognizing the deductions and credits that apply to your situation, and their algorithms are getting more advanced every year. If you hire a CPA, I bet they’re also pretty good at recognizing the deductions and credits that apply to your situation. If you miss one, don’t panic! You’ll probably have the opportunity to “amend” your tax return and claim what’s rightfully yours. (This happened to me, and I’ll share that story in my next post.)
Even though CPAs and online tax services are typically really good at finding your deductions and credits, stuff happens. It’s beneficial for you to be familiar with the deductions and credits that can apply to your situation. You should be able to check your tax return before it’s filed, but if not, you can always do your due diligence afterward. (Just remember, it takes another step if you have to check after you file.) Either way, keep the following deductions and credits in mind:
Note: The following deductions are available whether you itemize your deductions or not. There are many rules and limits that may apply; visit the IRS website to learn more. If you itemize your deductions, there are many additional deductions that may apply to your situation. Check out my last post to learn what’s available as itemized deductions and whether itemizing is right for you.
Here are some common situations that may call for a tax deduction. Do any apply to you?
Did you go to school or pay student loans?
You may be able to deduct some of the tuition and fees you paid in 2016. The expenses must be for higher education (post-high school, in other words, college or vocational schools). You may be able to deduct up to $4,000 of “qualified expenses” (e.g., tuition, books, and supplies).
If you’re paying back student loans, you may be able to deduct up to $2,500 of the interest you paid on your student loans in 2016. The student loan must have been taken out to help pay for higher education.
Did you move due to a change in your job?
You may be able to deduct reasonable moving expenses that you incurred within one year from when you first started your new job. The IRS doesn’t make this deduction easy, though. There’s a distance test and a time test you have to pass: Your “new workplace must be at least 50 miles farther from your old home than your old job location was from your old home”, and “you must work full-time for at least 39 weeks during the first 12 months immediately following your arrival in the general area of your new job location.” Visit the IRS website for more details. (Note the rules are slightly different if you’re self-employed.)
Did you contribute to an IRA or an HSA?
The Individual Retirement Account (IRA) contribution limit for 2016 is $5,500 ($6,500 if you’re 50 or older). You may be able to deduct the amount you contributed in 2016. There are rules and limits that may apply here. And the amount you’re able to deduct could depend on whether you’re covered by a retirement plan at work. Note: Roth IRA contributions are not deductible.
The Health Savings Account (HSA) contribution limits for 2016 are $3,350 if you have a single plan and $6,750 if you have a family plan. (Remember: You can only contribute to an HSA if you have a high-deductible health plan.) Again, there are rules and limits that apply here.
Additionally, you’re only allowed to claim a deduction for the amount that you personally contribute to the account after taxes (i.e., you can’t claim a deduction for any contributions made by your employer). If you contribute to your HSA pre-tax via your employer’s cafeteria plan, you won’t be able to claim the deduction (although it still helps because you are reducing your taxable income). You’ll only be able to claim the deduction, for example, if you contribute to your HSA with money from your bank account.
Are you self-employed?
If you’re self employed, you probably know by now that your taxes are a bit more complicated than if you worked for someone else. You may, however, be able to claim a few deductions. There are many rules that may apply here, too. (Yup, it’s always a common theme when it comes to the IRS.) You may be able to deduct medical, dental, and/or long-term care insurance premiums that you pay for yourself, your spouse, or your dependents.
Similar to an IRA contribution (see above), self-employed folks may be able to deduct contributions to self-employed retirement plans such as Simplified Employee Pension (SEP) plans (maximum contributions are 25 percent of compensation up to $53,000 for 2016) and/or Savings Incentive Match Plan for Employees (SIMPLE) plans ($12,500 contribution limit for 2016, or $15,500 if you’re age 50 or older).
Note: The following credits may be available whether you choose to itemize your deductions or not. There are many rules and limits that may apply; visit the IRS website to learn more.
Here are some common situations that may call for a tax deduction. Do any apply to you?
Did you go to school?
You may be able to take a tax credit for some higher education tuition and fees you paid in 2016. There are two available credits: Lifetime Learning or American Opportunity. Spoiler alert: You can’t take both. It’s one or the other. You also can’t take the Tuition and Fees deduction (mentioned above) if you take either of these tax credits.
The American Opportunity credit allows you to take a credit for 100 percent of the first $2,000 of qualified education expenses, plus 25 percent of the next $2,000 of qualified education expenses (maximum annual credit of $2,500). The Lifetime Learning credit is worth up to $2,000 per year on your tax return.
I know what you’re thinking: Which one do I take? Remember how I said that online tax programs are getting really sophisticated these days? That applies here, too: They’re able to analyze which deduction or credit will yield you the best results. If you have a CPA, he or she should be able to weigh each option and recommend the best solution.
Do you have kids?
Your kids might be a pain in the behind, but they may be able to benefit you when tax season comes.
You may be eligible to claim a credit for child and dependent care expenses. (Of course, there are many rules that apply to this credit.) The amount of the credit can be between 20 to 35 percent of your allowable expenses. The maximum credit is $3,000 for one qualifying child and $6,000 for two or more qualifying children.
The Earned Income Credit may be available for individuals with lower incomes (Adjusted Gross Income of about $15,000 to $48,000 if you’re single, depending on the number of children you have). You may be eligible for a credit of between $500 to $6,270, depending on how many children you have. The IRS makes this credit a tricky one to take, however. There are many rules and limits that apply. Your online tax service or CPA should be able to find the solution.
You may also be eligible for the Child Tax credit. The credit amount may be $1,000 for each qualifying child under the age of 17. The best thing about the three aforementioned credits is that they’re not mutually exclusive. You may be able to take all three credits if you meet all of the requirements.
Do you own a house or condo?
Nope, you don’t automatically get a credit for owning a house or condo. (That would be a pretty sweet incentive, wouldn’t it?) If you installed something that improves the energy efficiency of your home, however, you may be able to claim a credit for a percentage of the cost. These energy efficiency credits can be broken into two parts:
- The IRS says “you may be able to take a credit of 30 percent of your costs of qualified solar electric property, solar water heating property, small wind energy property, geothermal heat pump property, and fuel cell property.”
- You may also be able to take a credit for other energy improvements that you make to your house. The credit has some limits, though. Installations of insulation, exterior windows and skylights, exterior doors, and certain HVAC systems like water heaters and central air conditioning systems may qualify.
Aren’t tax deductions and credits exciting? Trust me, even though they seem really complicated and have tons of rules, you’ll be pumped when you realize that you qualify. Re-read my list and see if any of the situations apply to you. Then, check through your tax return to see if any were included. If they are, give yourself, your online tax service, or your CPA a pat on the back. If they aren’t, do a bit more research to see if you qualify. If you think one was missed, you can typically go back and amend your return. I had to redo mine once. I’ll share the story next time.
Tyler is a CERTIFIED FINANCIAL PLANNER™ practitioner who believes financial education can empower people to reach their goals.
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