1. What is the difference between a tax credit and a tax deduction?
Tax deductions reduce your gross income where as tax credits reduce the amount of tax you owe to the government. Tax credits are more valuable than tax deductions. For example, if you made $50,000 in 2019, a tax deduction of $5,000 would reduce your income to $45,000. To keep things simple, if your tax rate was 10% for the entire $45,000 which is only a hypothetical scenario that is impossible due to the progressive nature of the tax system, you would owe $4,500 to the government.
Now, if you had a $4,500 tax credit, the $4,500 owed to the government would be eliminated and you would owe nothing. Tax deductions can only reduce your INCOME where as tax credits reduce the amount you OWE to the government. Some tax credits are even refundable which would put money in your pocket.
2. Refundable Federal Tax Credits
Refundable tax credits have the ability to put money in your bank account. Going back to the previous example, if you owe $4,500 to the government and receive a tax credit for $5,000 that is fully refundable, then you would receive a $500 deposit to your bank account. A nonrefundable tax credit of $5,000 would only reduce the $4,500 you owe to the government to $0 thus refundable tax credits are the BEST way to reduce the taxes you owe. Here is a list of the most common refundable tax credits:
- Earned Income Credit- Aimed at low income households with dependents or adult college students between 19-23. A dependent does NOT have to be a child. Dependents can be the son, daughter, adopted child, sister, brother, half-brother, half-sister or a descendant of one of these such as a grandchild or a nephew/niece. Find out if you are eligible to claim the EITC in the IRS’s website: Do I qualify for EITC?
- Child Tax Credit- Dependent 16 and under
- American Opportunity Credit- Aimed at College students. Parents can claim it for their children who attend college. You can receive a check up to $1,000.
3. Nonrefundable Tax Credits:
- Dependent Care Credit- Dependents 12 and under that go to daycare or disabled spouses. Once again, a dependent does not have to be a child. It can be a brother, sister, grandchild, step brother, step sister, son, daughter, adopted child or a descendant of one of these such as a nephew/niece. You can also claim the credit if you pay a family member or friend to take care of your child in your own house as long as it is not your spouse or someone you can claim as a dependent. For example, you can hypothetically pay your mom to take care of your child who is under 13 and claim the credit.
- Credit for other Dependents- Other dependents are relatives who are not a qualifying child such as your mother, father, uncle, aunt cousin etc who qualify as your dependent. It also does not have to be a blood relative. It could be a total stranger that lived in your home for 12 months. The credit is $500 per person. If you work and take care of a qualifying relative such as your mother, you could be eligible to claim this credit.
- Energy Tax Credit- Credit for solar panels, solar water heaters, geothermal heat pumps, wind turbines etc. Also, energy efficient improvements such as exterior windows, doors, skylights, insulation, certain roofs, hvac and water heaters may qualify.
4. Best Tax Deductions:
The best tax deductions are above the line tax deductions because you can claim them while also claiming the standard deduction. Itemized deductions can only be claimed if you do NOT claim the standard deduction. To simplify all of this, here is a formula to show you how the tax system works:
Gross Income ($50,000)
– Above the Line Deductions ($10,000)
= Adjusted Gross Income ($40,000)
– Itemized or Standard Deduction (Pick whichever gives you the highest deduction)
= Taxable Income (Amount of income you will be taxed on)
* Tax Rate (Federal tax rate)
= Tax Owed (Amount you have to pay the government before tax credits)
– Tax Credits (Reduces the tax you owe the government)
= Tax Owed after Credits or Tax Refund after Credits (Final amount you will owe or receive a refund)
Here is a list of ABOVE THE LINE DEDUCTIONS:
- Educator Expenses- Teachers, teachers aide etc up to $250
- Student Loan Interest Paid- Up to $2500
- IRA- Up to $6,000 (Everyone should have an IRA or Roth IRA as early as possible)
- Alimony Paid- If divorce decreed before Jan 1st 2019
- Self employed health insurance premium
Here is a list of ITEMIZED DEDUCTIONS:
- Mortgage Interest
- Property tax, Sales tax, State tax, Local tax- limit $10,000
- Medical expenses
Many charities promote donating for tax deduction purposes but if you are going to claim the standard deduction over the itemized deduction which most people do after the new tax laws, then donating to charities will not provide any tax benefit for federal tax purposes. However, there may be a state charity credit such as in Arizona which you may benefit from that most people are not aware of.
If you have missed any credits in the past 3 years, you may amend your return and still receive a refund. However, tax returns past 3 years are not eligible to receive a refund. If you have tax returns from 2016, 2017 and 2018 where you may have missed tax credits or deductions, it is crucial you file an amended return as soon as possible. Many people do not file tax returns because they believe they did not make enough money or are scared they might owe money. In reality, if your employer held federal income tax from your paychecks and you did not make enough to owe taxes or had deductions and credits to offset taxes, then you have given the government YOUR money for FREE that you will never get back unless you file a return. Check box 2 on your W2s from the past 3 years to see if your employer held federal income tax which you might be entitled to receive back from the government.
If there is anything in the world you need help with or are looking to buy or sell in the future, save my number as “Realtor Lasker” at 480-779-8579 and my email at TaxesAndRealty@gmail.com. Good luck.