Mark Twain stated that two things were for sure in life: taxes and death. The statement rings true today. Everyone who earns a dollar has to file an income tax return with both the federal and state governments.
However, once one gets into the process of filling out a tax return, there’s a whole world of possibilities that can occur. The tax code, both at the federal and state levels, provides for a number of opportunities where a filer can reduce his taxes owed. These adjustments are typically seen in the form of a tax credit or a tax deduction.
Fundamentally, a tax credit gives more of an adjustment than a tax deduction. So to the extent a filer is eligible for tax credits, he should take them when possible. A tax credit allows an adjustment on taxes owed, dollar-for-dollar. This means, for example, if you get a tax credit for $1,000 and you owe $5,000 in taxes, with the credit applied you will only owe $4,000, an adjustment downward of the same $1,000 the credit was worth.
Tax credit can result in a tax refund, even when no taxes are owed. In these instances, the government is in essence paying tax filers for meeting certain requirements. Tax credits are often used for social engineering, encouraging people to act in a certain way to get the credit. One of the most recent examples has been tax credits provided to filers who buy hybrid green cars or those who weatherize their homes to make them more energy-efficient.
A tax deduction allows an adjustment to your income taxed. This is not the same as taxes owed. For example, if you earned $50,000 in taxes and you own a home, you may be eligible for a tax deduction for property taxes paid. If you paid $3,000 in property tax, your income eligible to be taxed would reduce by some amount of the $3,000 allowed by the tax code. So let’s assume it drops $2,500. Your taxable income would then be $47,500. Going into the tax brackets, you would then owe some amount for taxes based on $47,500 versus your original income figure of $50,000. The end result may be reduction in your taxes paid, but it’s far more convoluted than the straight dollar-for-dollar adjustment of a tax credit.
Further, tax deduction eligibility can change from year to year. Many filers can choose whether to take a tax deduction or not, instead opting for what is called the standard deduction, a set dollar adjustment amount provided by the federal government for every filer on a tax return. Sometimes this is the easier way to go rather than figuring out each and every miscellaneous deduction possible.
Tax deductions do not result in tax refunds per se. If a person has withholding, and anyone who gets a paycheck from an employer does, deductions can result in getting more of your pre-paid tax withholdings back; however, unlike a tax credit, deductions do not generate tax refunds when no further taxes are owed.
Finally, unlike tax credits, many in government don’t prefer tax deductions. They are too open-ended and abused. Too often, filers claim tax deductions that are not warranted or documented, only getting caught when audited. The home office tax deduction is a common example of a deduction claimed far too often without proof by those running their own small business. In some cases, much discussion tends to occur about phasing deductions out. In 2011, one of the major topics was the possible phase-out of the mortgage interest tax deduction, disallowing people from claiming their home loan interest payments as a deduction.
Whichever is the case that applies, tax filers are best served by having a licensed tax preparer look over their draft returns before filing. The IRS and state tax agencies don’t mind people changing their minds before filing. However, once a tax return is filed, the filer better be able to show paperwork proving the tax credit or tax deduction eligibility if reviewed or audited. Not being able to do so can result in further taxes owed.