Tax Credits Vs. Tax Deductions
Hi everyone, and welcome back to Melissa Making Cents!
As your beloved neighborhood CERTIFIED FINANCIAL PLANNER™ and Financial Coach, I'd like to take an opportunity this week to talk about something most of us dread year-round. It's not a serial killer or the boogieman, but to some adults, it's even more worrying. What I'm talking about is that apprehensive and anxiety-inducing time of year that's almost universally hated… TAX SEASON.
If you're not already starting to get organized and preparing to file your taxes, this is your sign that it's time to begin. Unfortunately, though almost all of us know tax season is starting, there are many of us who avoid it at all costs until the last possible minute to file. According to IPX, around thirty-three percent of the population waits until the last minute each year to file taxes. The reasons range from time consumption and stress to being worried about owing money. However, this procrastination really just leads to more stress in an already stressful situation.
By keeping good records and filing your taxes (with time to spare), you're freeing yourself up to be able to make changes before you do the deed of submitting your paperwork. Also, by getting your taxes submitted early, you're essentially using a fast pass to jump to the front of the line when it comes to getting your refund. And while I'm not a tax planner, I do think it's an excellent financial practice to talk to those who you care about and make sure they're on track with their tax preparation and progress. In other words, friends don't let friends accumulate tax penalties.
Tis the Season – For Taxes
Before we get into the meat and potatoes of this article, I'd like to go ahead and talk about hard deadlines. That is – I'd like to remind all of you what the tax deadline, is when it comes and what will happen if you miss it. I know that this information can be somewhat uncomfortable for many people, but it's essential to get out there to learn the timelines we must meet and the consequences of not meeting them.
Okay – so the season for taxes this year (in 2022) has already begun. The ability to do your taxes and get them into the IRS and your state department of revenue is open. If you're an early-doer, congratulations! However, if you haven't begun the process, the time is now, as the federal deadline for submitting your taxes to the IRS is April 18th. While that seems like a long time from now (and there's a possibility the deadline will be extended as it has been the last two years), it'll be here before we know it, and we shouldn't be counting on an extension to save us.
After that, the due date to file an extension with the federal government is April 19th, the day after taxes are due. Lastly, the deadline to file for those who requested a federal tax deadline extension is October 17th. These dates are incredibly important. If you don't get your taxes done on time or file an extension, you'll be on the hook for somewhere between 4.5% of your owed taxes per month for not filing on time, as well as a .5% interest fee. So, in other words, let's just go ahead, hop on those taxes and get them done.
Tax Credits – The Basics
I'm not going to mislead anyone – for those of us who aren't tax experts, terms like tax credits and tax deductions can get really confusing quickly. Luckily clearing up the confusion surrounding these two specific terms is precisely what this post is covering. However, I'd highly recommend working with an outstanding tax advising professional to ease into all of this.
Just to have a basic understanding of what a tax credit is – a tax credit is essentially the government reducing the amount of income tax you owe when you meet a specific requirement. According to TurboTax, "Tax credits reduce the amount of income tax you owe to the federal and state governments. In addition, credits are generally designed to encourage or reward certain types of behavior that are considered beneficial to the economy, the environment or to further any other purpose the government deems important."
When discussing tax credits, it's important to point out that there are two main types: refundable and non-refundable. This is a critical distinction, as it changes quite a bit about how tax credits operate. For example, with a refundable tax credit, you're able to be refunded the difference between how much of it is applied towards your owed taxes.
However, with a non-refundable tax credit, any money that's not applied to your owed taxes is returned to the government. So, for example, if you were to be given a refundable tax credit for $500, but you only owe $400 in taxes, you'll receive the remainder as a refund $100. In a similar situation, if you're given a $500 non-refundable tax credit but only owe $400 in taxes, then you will not receive the difference as a part of your refund.
There is also a third option – a partially refundable tax credit. With this type of tax credit, you'll be able to have a portion of the unused tax credit refunded. This portion is typically a percentage of the remainder.
Some popular examples of tax credits include:
- Child and Dependent Care Tax Credit
- American Opportunity Tax Credit
Tax Deductions – The Basics
According to Investopedia, a Tax Deduction is "an expense that taxpayers may use to lower their taxable income and thus lower the amount of taxes they owe." In other words, while you're essentially given money to subtract against your taxes with a tax credit – with a tax deduction, you're able to deduct qualifying expenses from the total amount of tax that you owe. These subtle differences make it obvious and easy to see why many people have issues differentiating the two.
Tax deductions can be tricky business for the everyday tax-filer. To claim deductions, there are two routes one can take. One can take the "standard deduction" or itemize their deductions. Deciding which to do can be difficult, especially if you're doing your taxes independently. With the standard deduction, the IRS allows up to a certain amount of deduction from your taxes point-blank without any further research or digging. According to Nerd Wallet, in 2022, filing as single, you'll be able to claim $12,950, filing Married-Joint $25,900, filing married-separately $12,950, and filing as the head of household $19,400. This is a substantial amount to deduct from your taxes; however, it's possible to remove even more by itemizing.
With itemization, you'll be able to claim multiple deductions and an exact amount for each removal to lower your owed taxes. This process can result in a larger overall deduction, but it can be confusing (and scary) to the average Joe. If you decide to itemize while claiming deductions, make sure you're holding onto all files and record what you did and why you did it just in case the IRS audits you.
Some popular examples of tax deductions include:
- Mortgage Interest
- Charitable Contributions
- Medical Expenses
How Tax Deductions and Credits are Different.
Now that we've outlined the basics of both Tax Credits and Tax Deductions let's talk about how they're similar and different from each other. While both tax credits and tax deductions do the same thing (lowering the amount of money you must pay in taxes), how they're different is how they operate.
Tax credits lower the amount of money you owe in taxes on a dollar-for-dollar basis by "giving" you money that counts against the taxes you owe. This is different from a tax deduction, which reduces your overall taxable income. Also, with a refundable tax credit, you're able to claim the difference between your applied tax credit and your owed taxes.
Is One Better than the Other?
Typically given a question like this – I'm very tempted to say that "no, one isn't better than the other because the two options are inherently different. However, a case can be made that a tax credit is better than a tax deduction. This is for a few reasons. Reason number one is that the tax credit lowers the amount of taxes you must pay dollar for dollar, while a deduction only reduces your overall taxable income. Secondly, and more obviously, a specifically refundable tax credit can give you money back with the rest of your tax refund while a deduction doesn't. However, I'll leave it to you and your tax advisor to decide which is best in your exact situation.
Claiming Tax Credits.
Claiming tax credits is a little bit more involved than filing for either standard or itemized tax deductions. To claim tax credits, there is a little bit of research required on the front-end. Firstly, we must research which tax credits we would like to apply for. Next, we must make sure that we meet all of the requirements for the credit. Once that's done, we must research the exact needs and forms associated with each credit.
How to Claim Deductions.
To claim tax deductions, there are two routes you can take. Either you can claim the standard deduction by correctly filing the Schedule a FORM 1040 OR THE 1040-SR for seniors. Doing so mostly comes down to checking the correct boxes. As for filing itemized tax deductions, the filer must correctly file the Schedule A Form 1040. However, if choosing to itemize, the filer should also make sure they're keeping good records of all selected deductions to provide proof if need be.
To decide if you should claim the standard tax deduction (whether that be married/joint, married/separate, head of household, or individual), it's always best to run the numbers. Doing this correctly can be a bit arduous; however, there are multiple online tools that can help you complete this process. To ensure it's done correctly and that the correct choice is made at the end of the day, I'd highly recommend working with a tax advisor who knows the ins and outs of tax deductions.
What are Tax Exemptions, and How are They Different?
Tax exemptions are a beast of their own. However, they're often commonly confused with tax deductions. This is totally understandable, especially considering they work very similarly. In essence, a tax exemption lowers the total amount of taxable income an individual will owe a percentage of. Where tax exemptions get sort of hairy and confusing is when discussing how many exemptions can be claimed. As far as personal exemptions go, a non-dependent is able to claim one tax exemption, and a married couple is allowed to claim two (one per person). If you have a child or are dependent, you may be able to claim each as an extra exemption.
The Benefits of Working with a Tax Advisor!
Understanding the differences between all these tax terms is critical. Tax exemptions, tax deductions, tax credits, and everything else work together to get you the best deal possible come tax season. However, the unfortunate truth is that these rules and regulations aren't meant to be very easy to understand. And because they aren't easy to understand, many of us don't!
Perhaps the best way to combine any amount of knowledge about taxes and ensure that you're in the safe lane is to work with a tax advisor or tax preparer! These professionals work around the clock during tax season (and the rest of the year) and know the rules inside and out to get you the best possible tax return (while owing as little as possible).
Are you interested in learning more about certain tax credits and tax deductions? Or are you interested in someone helping you find a great tax advisor or tax planner who can help you during that time of year? Please call or email to schedule an appointment with me. I'll work with you to create a financial plan that incorporates excellent record-keeping to help both you and your tax planner come tax season.
Until next time...this is Melissa Making Cents!
Melissa Anne Cox, CERTIFIED FINANCIAL PLANNER™, is a College Planning and Student Loan Advisor and Financial Coach in Dallas, Texas.