Tax lingo, even without getting into the weeds of the Internal Revenue Code, tax regulations, IRS rulings, etc., can be confusing. Two frequently used terms that taxpayers sometimes think provide the same tax benefit, but don’t, are “tax deductions” and “tax credits.” Although a tax deduction and a tax credit both help lower the taxpayer’s tax, there’s a difference between them, and there are distinct types of deductions and categories of credits. This article explains these terms. In general, a deduction reduces taxable income, whereas a credit reduces the tax itself.
Tax Deductions – Tax deductions reduce the taxable portion of an individual’s income, which then reduces the tax on that income. But tax deductions come in a variety of flavors, as explained next:
Above-the-Line Deductions – Certain deductions actually reduce income. These are commonly called above-the-line deductions because, when applied, they reduce the income figure that is used to calculate AGI. Thus, their benefits apply regardless of whether the taxpayer uses itemized deductions. Above-the-line deductions include educators’ expenses; contributions to health savings accounts, traditional IRAs, and certain qualified retirement plans; deductible alimony payments; and student-loan interest. Most of these deductions have annual maximums (not discussed in this article).
Below-the-Line Deductions – These are deductions allowed without having to itemize that reduce a taxpayer’s taxable income but not their AGI. For example, for 2021 taxpayers who don’t itemize their deductions are allowed a limited deduction for cash charitable contributions. That donation to charity is a below-the-line deduction. Normally, charitable contributions are only allowed when itemizing on Schedule A.
Another below-the-line deduction is the Section 199A qualified business income deduction that is generally 20% of net business income from pass-through activities.
You may wonder: why bother to distinguish between above- and below-the-line deductions? The AGI is used for applying limitations and phaseouts for a variety of deductions and credits. While Congress wanted taxpayers to benefit from below-the-line deductions, the legislators didn’t want taxpayers to benefit too much – they didn’t want the AGI to be reduced by these deductions because that could have resulted in more generous other deductions and credits.
Business Deductions – Taxpayers who operate noncorporate businesses can deduct from their business income expenses that they incur when operating their businesses. These deductions (which cover advertising fees, employee wages, office-supply costs, etc.) are used to reduce profits, which in turn reduces AGI and taxable income and, ultimately, income tax. In addition, most self-employed taxpayers pay Social Security and Medicare taxes on their net business income, so any reduction in their business profits also reduces their Medicare taxes and possibly their Social Security taxes.
Asset-Sale Deductions – An individual who sells an asset is allowed to deduct that asset’s cost from the sale price to determine the taxable profit. Good recordkeeping is helpful here because the original expense may have been incurred years prior, even though it is only deductible when the asset is sold. For example, any improvements that an individual makes to a home over years of ownership are not deductible until the home is sold. At that point, the individual can reduce the taxable gain from the sale by counting the improvements as part of the home’s cost.
Tax Credits – Tax credits come in several varieties, and the amount of benefit can vary:
Nonrefundable Credits – A nonrefundable credit only offsets tax liability; any unused amount is lost (unless it can be carried over to another year; see below). Over time, Congress has become more generous with credits; most credits that are not refundable now carry over for a given period. Nonrefundable credits include the Saver’s Credit, the Lifetime Learning Credit, and the Child and Dependent Care Credit.
Carryover Credits – For some nonrefundable credits, any unused current-year credit can be carried over to the next tax year (or for a longer period) until the carryover amount is used up. These credits include the Adoption Credit (which can carry over for up to five years) and the Home-Solar Credit.
Business-Tax Credits – Numerous business-tax credits are available; however, they are grouped into the General Business-Tax Credit, which is nonrefundable but if the credit exceeds the tax, the credit is eligible to be carried back for one year and forward for up to twenty years. (The carryback provision allows a business owner to amend the prior year’s return so as to claim the credit.)
If you have questions related to how you might benefit from tax credits or deductions, please call this office.