Individual income tax returns have many moving parts, but they can be broken down into a few big categories. In this tax basics post we will examine the big three areas of the tax return, which are income, deductions, and credits. For context, here is an overview of how these elements fit into the tax calculation:
Income
It is called an income tax return for a reason. If nothing else in this list applies, this one will. With few exceptions, if there is no income, there is no need for an income tax return.
There are several types of income, the most common of which is wages, salaries, and tips reported to you on a form W-2 by your employer. There are many types of income, but some other common ones include investments, retirement, and self-employment.
Deductions
Deductions can be broken down into two main categories: deductions for AGI and deductions from AGI. AGI, or "adjusted gross income," is a baseline that is used for many calculations through the remainder of the tax return, on many state tax returns, and on many other financial forms in other areas of life.
Deductions for AGI
Because many other calculations, including many states' tax forms, use the AGI as a baseline, deductions for AGI are more beneficial than deductions from AGI in saving you money when tax day comes. Some common deductions for AGI are health savings accounts (HSA) deduction, IRA deduction, student loan interest deduction, and tuition and fees deduction.
Deductions from AGI
After AGI is calculated, the most common deductions come into play. Either the standard deduction or itemized deductions are subtracted to arrive at taxable income. Another deduction from AGI that applies to business owners and some investors is the qualified business income (QBI) deduction.
Credits
After taxable income is tabulated, the tentative tax is calculated. This is the starting point, but we will try to find credits to whittle away at this amount to reduce the balance due or increase the refund. Credits, like deductions, come in two flavors: nonrefundable credits and refundable credits.
Nonrefundable Credits
As the negative prefix in the name implies, these credits have a limitation to them. The sum of nonrefundable credits cannot be greater than the tentative tax that was calculated on our taxable income. If these credits are greater than the tentative tax, that tax is reduced to zero, but it cannot become negative.
Some common nonrefundable credits are the child tax credit*, dependent care credit, education credits (American opportunity tax credit and lifetime learning credit), retirement savings credit, and residential energy credits.
After subtracting all of these credits, we arrive at total tax, which again, cannot be less than zero.
Refundable Credits
After we arrive at total tax, we look at refundable credits to further reduce our balance due or increase our refund. While each of these credits may have individual limits, there is no global limitation on refundable credits, and these credits can pay out even if the total tax is already zero.
Some common refundable credits are the earned income credit (EIC), additional child tax credit*, and the American opportunity tax credit.
*The child tax credit is commonly referred to as a single credit, but for many individuals it is bifurcated between the child tax credit (CTC) and the additional child tax credit (ACTC). The CTC is a nonrefundable credit, so for individuals where the CTC is limited by their tax liability, the ACTC allows a portion to be paid out as a refundable credit.
The American opportunity tax credit (AOTC) works in a similar way, where if the nonrefundable credit is limited, a portion may be able to be paid out as a refundable credit.
Refundable credits are combined with amounts withheld from paychecks or other payments. This total is subtracted from total tax. If this difference results in a negative number, the IRS owes you a refund. If the balance is greater than zero, this is the amount you still owe at tax time.
Deductions vs Credits
Both deductions and credits reduce the amount of tax due, so what is the main difference here? Notice in the tax calculation illustration above that deductions are all applied prior to the "tax calculation magic" as I glibly referred to it, while credits take place after this point. This means that credits directly reduce the amount of tax due, on a dollar-for-dollar basis. Deductions, on the other hand, only reduce your tax base. Therefore a deduction is only worth a fraction of a dollar, and this fraction is based on your marginal tax bracket. Let's look at couple examples:
Example 1: a $1,000 deduction
Lilibet makes $40,000 in tax year 2021. Her cousin Charlotte makes $70,000 the same year. Each of them is eligible for a $1,000 student loan interest deduction. Let's compare each of their taxes with and without this deduction.
Lilibet's taxable income with no deductions is $40,000, which puts her in the 12% marginal tax bracket. Her tax would be $4,600. When we add in Lilibet's $1,000 deduction, her taxable income is $39,000, still in the 12% bracket. Her tax in this situation would be $4,480. This is a savings of $120, or 12% of her $1,000 deduction.
Charlotte's taxable income with no deductions is $70,000, which puts her in the 22% marginal tax bracket. Her tax would be $11,149. When we add in Charlotte's $1,000 deduction, her taxable income is $69,000, still in the 22% bracket. Her tax in this situation would be $10,929. This is a savings of $220, or 22% of her $1,000 deduction.
Example 2: a $1,000 credit
Lilibet and Charlotte have both discovered they are eligible for a residential energy credit of $1,000. Let's compare each of their taxes with and without this credit.
Lilibet's tax was calculated to be $4,480. She takes a credit of $1,000, and her balance is $3,480, a savings of the full $1,000.
Charlotte's tax was calculated to be $11,149. She takes a credit of $1,000, and her balance is $10,149, a savings of the full $1,000.
So what can we conclude from this? Are credits always better than deductions? No, not always. A deduction must be several times the amount of a credit to result in the same savings, but sometimes this is possible. One example is the tuition deduction versus education credits. In some circumstances it can be more advantageous to take the tuition deduction because it can be more generous and the education credits can be limited. In situations where a deduction and a credit are pitted against each other like this, it is always best to calculate taxes both ways to see which results in a better outcome. Additionally, it can be beneficial to load up on deductions for AGI because the AGI is used throughout the remainder of the tax return. For example, if a deduction reduced AGI enough to make us eligible for an additional credit, that deduction is worth much more to us than it would have been otherwise.
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