Tax Credit vs. Deduction

Posted by PhroBoy - Financial Wonderboy | Finance | Saturday 12 June 2010 8:08 am

The not so mighty, but still Afro and Whitey younger brother, PhroBoy provides everyday tips regarding how to manage your wallet – most relevant to those making less than $100,000 in total household income.  He has recently started working as a tax consultant for a large public accounting firm and being poor, young and married has some practical advice regarding your finances.

I do not profess to be a tax expert, but I realize that I understand more than most. I warn you that with my background in tax and accounting, I have a tendency to be too technical. If you ever find that is the case or you do not understand something, please post a comment, and I will try and respond with a simpler explanation.   My goal is to save you money!

I’m pretty sure the following language is necessary with anything I post about:

This information is not intended or written to be used, and it cannot be used, for the purpose of avoiding U.S. federal, state or local tax penalties.

With this post, you can follow along and learn by referring to the U.S. Individual Income Tax Return Form 1040.

What is a tax credit vs. a tax deduction?

  • Tax Deduction

A tax deduction is something that reduces your taxable income, the base on which the tax you owe is calculated.

In tax, you break up deductions between “above the line” items and “below the line” items with the line referring to your Adjusted Gross Income (AGI), the last line on page 1 or first line on page 2.

Your AGI is important for several reasons, and generally, you want it to be as low as possible. Your AGI is used to determine limitations on other deductions (i.e. – if you itemize, medical expenses are reduced by 7.5% of your AGI). Your AGI can be the starting point for your state tax return as well, so above the line items may reduce your state taxes where below the line items may not.  If you look at the 1040, everything on page 1 is an above the line item. Contributions to a Health Savings Account (HSA, subject of future post), moving expenses, educator expenses, student loan interest, contributions to a qualified traditional Investment Retirement Account (IRA, also subject of future post), etc.

Below the line items include the items on page 2. This would be your standard deduction or itemized deduction (you take the larger deduction of the two), personal exemptions (for those you can claim as dependents, including yourself), and special items for the elderly or disabled.

Notice that on line 43 you arrive at and calculate your taxable income, different from AGI, and on line 44 you calculate the total amount of tax you owe (your tax liability) using graduated tax rates. Notice, no credits have come into consideration.

  • Tax Credit

A tax credit is a special gift from the government. Both these and many deductions vary by tax policy. Credits are very politically driven and can change quite often.

Remember that you have calculated the amount of tax due on your taxable income before considering any tax credits. Credits are like deductions of the tax you owe as opposed to deductions which reduce your taxable income.

Let’s say you have $50,000 of income. Both your above the line deductions and below the line deductions reduce your taxable income by $20,000 leaving you with $30,000 of taxable income. The tax you owe (your tax liability) is a percentage of your taxable income according to graduated rates (you can use the tax income tables provided in the 1040 instructions to make it easier). For the sake of the example, assume you had a 10% tax rate on that income resulting in a tax liability, amount you owe, of $3,000.

Any credits you qualify for can reduce that $3,000 tax liability to zero even if your credit is greater than your tax liability unless it’s a refundable credit.

  • Refundable Tax Credits

Refundable credits are fantastic, especially if you can manage to reduce your tax liability to zero.  After your tax liability is reduced to zero, you get a refund for the remaining amount of the credit.

Using the previous example, let’s assume you qualify for a $3,500 Lifetime Learning credit which is a non-refundable credit. Since this is not refundable, your credit is limited to your tax liability or $3,000. You do not get any benefit from the extra $500 you qualified for.

Continuing the scenario, let’s assume you also qualify for the Making Work Pay refundable credit for $800. Now your tax liability has already been reduced to zero by the Lifetime Learning Credit, but the Making Work Pay credit is refundable meaning the government will send you a check for $800.

Thanks to refundable credits, my family received over $12,000 as a tax refund this year without paying or withholding a single dollar from my paychecks. The entire check came from refundable credits (2009 had lots of them).  Granted, I only received that money because I do not make very much money, but through proper planning, you can make sure you take full advantage of the deductions and credits available to you.

Takeaways & Strategy

Depending on your situation, you may pick and choose whether you elect for a deduction or a credit.  For example, my wife and I had education expenses this last year.  There are 3 options we qualified for with these education expenses: lifetime learning credit, a $4,000 above the line deduction, or American Opportunity refundable credit (the expanded Hope credit for 2009, previously non-refundable).  I only qualified for the first two while she qualified for all of them.  However, you can only choose one for each person with qualified education expenses.

First, I checked to see if the $4,000 deduction (the limit per return, not person) would leave me with a $0 tax liability after applying everything except my refundable credits.  This would have been ideal because the lower AGI would have helped me to reduce my state tax liability since my state starts its tax calculation with my AGI.  However, this was not enough to bring my tax liability to $0.  I decided to use the lifetime learning credit because that completely eliminated my tax liability where the $4,000 deduction couldn’t  .

Second, after reducing my tax liability to $0, I was free to take all the refundable credits possible and receive a refund of all the money that was withheld from my paychecks.  We took the American Opportunity credit for my wife’s expenses, and we received the entire refundable amount of $1,000.

It is important to understand the deductions and credits available and how they affect your tax return as there is some strategy to be made.  You can’t be sure that any software or tax return preparer will catch the strategies available to you.  The software I used did not, and because I caught it, I saved over $500.  Take a look at your return and play with the numbers.  If you realize that you could get more money back, you can always amend your return and claim the money you are due.

How To Save For A House

Posted by stefu | Finance,How-to | Monday 1 June 2009 4:37 pm

Steven Smith (Stefu) is our resident financial expert at The Mighty AfroWhitey. You can follow him on Twitter (@StefuInvesting) or on his financial advice website, Stefu Investing.
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One of the largest investments that many of you will make in your lifetime is the purchasing of your own home. I wanted to share some ideas that should help you get into your first home, or renovate the one you already bought.

The 28% Rule

Those of you who are not yet homeowners are probably renting (or camping out in an abandoned part of town like I keep trying to convince my wife to try). If you are renting and want to save up some money for a down payment on a house, here is a useful tip that I have been trying. The first thing you need to know is what percentage of your income should be going toward your rent. Most experts will tell you that you shouldn’t spend more than 28% of your monthly gross income on your rent. So if you are making $5,000 a month, then you shouldn’t be paying more than $1,400/month for your rent (or mortgage payment).

Photo by Megan Ruth Stay
Photo by Megan Ruth Stay

So, Now What?

This brings us to my suggestion: if you should be able to afford $1,400/month and you are only paying $900 then it makes sense to put the extra $500 under your mattress to help save for that happy home you hope to have. Now, if you are in a 12 month lease, and you tuck your money under the mattress, you will come up with an extra $6,000 to help with that house down payment (or closing costs, or finder’s fees, or whatever you anticipate paying for in connection with that perfect picket fence).

Boost Your ReturnAssuming you want to get a better return than your mattress can offer (and a cheaper chiropractor bill), here is what you can do: save the first 6 months for a total of $3,000. Put this amount into a six month Certificate of Deposit and continue saving during this last six month period. This will give you a small boost in your savings while keeping it nice and safe.

Photo by Megan Ruth Stay

Photo by Megan Ruth Stay

If you already own a house, use this money to make those much-needed renovations you’ve been thinking about. Go ahead, get the wallpaper.

Want more ideas on building your budget and planning your financial future? Visit me at www.stefuinvesting.blogspot.com