Tax Deductions and Credits

The US government levies a tax on annual earnings. This tax is progressive, meaning that those who earn more are expected to pay a higher percentage of their earnings. Individuals and businesses are required to file tax returns each year to facilitate the process of calculating and collecting the monies due. Tax returns include all sources of income as well as any allowable reductions in that income in the form of deductions or credits. While deductions and credits both result in lower tax bills, the mechanism of each differs.

Deductions reduce taxable income by being subtracted from income totals. After deductions have been subtracted, the taxable income remains. The tax is calculated using this number. Credits reduce the amount of tax due after the deductions are subtracted and the tax due is calculated. Simply put, deductions lessen the tax liability at the start of the calculation, while credits lessen the tax due at the end of the process. There is often an income threshold for deductions and an income cap for credits, meaning those earning more are able to take advantage of deductions while those earning less are eligible for credits. As a result of these different vehicles, individuals at both ends of the earning spectrum are eligible for tax relief.

Background

The provisions of the tax code are a source of endless—and often contentious—debate. From people who claim that the very rich do not pay their fair share because of the deductions available to them, to people who think high taxes penalize success, nearly everyone has an opinion about taxes.

Congress writes the Internal Revenue Code (IRC) and has the constitutional power to levy taxes for the collection of revenue. Different provisions have been added to the US tax law since the tax code was first created in 1939 (remade from existing tax statutes). Because different parts have been approved and added, often in response to an earlier addition or change, the current IRC (last revised in 1986) is difficult to comprehend. It is also riddled with provisions that are directed at one or another constituent groups, often for the purpose of "getting something on the books."

Once tax laws are in place, the Internal Revenue Service (IRS) is tasked with putting the laws into action. It must collect the tax returns, process the returns, and refund amounts that have been withheld above what is due, or collect that not sufficiently withheld. Taxpayers have the right to contest any decisions by the IRS. They also have the right to ask for tax relief in the form of a payment plan if they do not have sufficient funds on hand to pay additional taxes.

Individuals and businesses can prepare annual returns themselves or pay tax preparers to do so. Many prefer to use a professional to be certain someone with knowledge and experience is overseeing the return. Many others prefer to use computer software that guides them through the process. Either way, returns, or request for extensions, must be filed by April 15 for individuals.

To facilitate the collection of monies due, the IRS withholds a portion of the estimated tax due from individual’s paychecks. This estimate is based upon the annual salary less the number of dependents for that family. For instance, a family of four would claim four deductions. With this in place, a certain amount of money is withheld from each paycheck so that at the end of the year, the amount due should be equal to or less than the amount withheld. (There are penalties if the difference between the two figures is too great.) If an individual gets a large portion of compensation from a bonus or nonsalary item, that individual may decide to claim more dependents so that a greater amount is taken out each year and the individual is not left owing far more than was withheld.

Overview

There are many different types of income deductions. All of these are subtracted before the total tax liability is calculated. One of the biggest deductions is that allowed for the interest paid on home mortgages. Topics of debate that surround this deduction are whether or not all mortgages are alike in the amount that can be deducted, whether or not there should be a cap on the size or portion of the mortgage that is subject to this deduction, and whether or not the deduction should be capped at a certain percent of income. In contrast, individuals living in rental homes do not receive deductions on their taxes for their rent.

Medical expenses are also subject to deductions. However, they must meet a threshold, meaning the expenses must total more than a certain percent of income before they can be deducted. There also may be a limit on how much of the medical expenses can be deducted, depending upon the income earned by an individual. Those with egregious medical expenses are particularly interested in this deduction and the income threshold provisions that go with it.

Deductions are also available for items like student loan interest and business losses.

Credits benefit those whose incomes do not meet the base requirement for deductions. The credits available for individuals include the child and dependent care credit, the adoption credit, the Earned Income Tax Credit (EITC), education credits, and the saver’s credit. All of these are subtracted once the tax liability is calculated.

The child and dependent care credit is available to households meeting the income requirements who provide for the care of qualifying individuals. It cannot be used to pay for private school or other education-related expenses. It must be used for child care necessitated by the work requirements of the parents or legal guardians, who must qualify to deduct this category as a credit. If a family is over the income threshold, that does not mean they do not pay for child care as a result of their work schedule; it simply means they are not in the income range that qualifies for this credit.

The adoption credit is based upon the income of the adoptive family or individual. If the income of that individual or couple exceeds the income threshold, no portion of the adoption expenses is eligible. Adoption expenses vary widely. Many times the fees paid are based upon the income of the family or individual adopting the child; however, since this is in the form of a credit, it is subtracted after the tax liability is calculated and is based upon the taxpayer’s income.

The EITC is valuable to those with a low to moderate income. It reduces the amount of tax due and may result in a refund. To qualify for this credit, those earning less than a stated income include the EITC on their return. Even if the individual is not required to file, they can claim the EITC. Many who qualify for the EITC are eligible for free tax preparation assistance as well. There is little downside to filing for this credit since the EITC payments are not used when deciding upon other benefits for those in the income group. These other benefits include such items as Medicaid, Supplemental Security Income (SSI), and food stamps.

Bibliography

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“Earned Income Tax Credit (EITC).” Internal Revenue Service, www.irs.gov/credits-deductions/individuals/earned-income-tax-credit-eitc. Accessed 12 Dec. 2024.

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