Tax Deductions & Credits Guide

Here we will break down what deductions and credits are, as well as point out the different types that are out there. Both can save you money, but they are also very different.

What’s a Deduction?

To put it simply, a deduction lowers your taxable income, and in-turn reduces your tax liability. It’s as simple as subtracting the amount of the deduction from your income. This lowers your taxable income. The lower that is, the lower your tax bill is. 

What’s a Tax Credit?

Tax credits can be just as simple to define. They are dollar for dollar reductions on your tax bill. So let’s say that you owe $500 on your taxes, but you qualify for $1000 in tax credits. Some tax credits are refundable. So you would get a check for the difference, which would be $500. Keep in mind that many, if not, most tax credits aren’t refundable.

The Difference

Let’s break it down with an example in the table below. In the left two columns you have what we will call the deduction route, and in the right two columns, you have the credit route. Let’s see how much a difference there can be. For example we’ll say that your adjusted gross income(AGI) is $50,000.

 

Deduction Route

Credit Route

AGI

$50,000

AGI

$50,000

Tax Rate

25%

Tax Rate

25%

Calculated Tax Without a Deduction

$12,500

Calculated Tax Before Credit

$12,500

Deduction

$5,000

Taxable Income

$45,000

Taxable Income After 

$50,000

Calculated Tax

$11,250

Calculated Tax

$12,500

What You Owe

$11,250

Credit 

$5,000

What You Owe

$7,500

 

As you can see, a tax credit can take a much bigger chunk out of your tax bill. The tax rate above doesn’t represent any particular tax rate. It’s a round number to simplify things. The U.S government uses a progressive tax system where tax brackets can change from year to year. 

How Do I Claim A Tax Deduction?

When it comes to claiming deductions, you have two options. You have the option to take a standard deduction or an itemized deduction. This all depends on your age, filing status, etc.

Standard Deduction:

Choosing the standard deduction is the simplest and fastest way to go. For most people, it is best to take the standard deduction. It has the least moving parts, and is just a flat reduction in your adjusted gross income. Here is an example of the amount you qualify for depending on your filing status.

 
Filing Status2019 Tax Year

2020 Tax Year

Head Of Household$18,350

$18,650

Single$12,200

$12,400

Married - Filing Jointly$24,400

$24,800

Married - Filing Separately$12,200

$12,400

Itemized Deduction:

The itemized deduction has the most moving parts, and can save you a bundle. The more itemized deductions you take, the less you’ll owe.   

The difference from the standard deduction is instead of applying a flat-dollar reduction from your adjusted gross income, itemizing allows you to break it down further. With itemizing, you’ll have the option to take any of the hundreds of tax deductions you may qualify for. Itemizing does take more time. You’ll need to proof that you qualify for these deductions, which typically requires more forms, and receipts.

Who Should Itemize?

Few scenarios exist where you have no choice but to itemize your deductions. Most people shouldn't have to, but if you're married but filing separately, you can't take the standard deduction if your spouse chooses to itemize their deductions. Also, some nonresident aliens may have no choice but to itemize as well. If your standard deduction is less than the final sum if you were to take itemized deductions. Then you should take the itemized deductions. 

Due to Tax Cuts and Jobs Act, the standard deduction has dramatically increased, so itemizing isn't worth it for most U.S. citizens.

If you still aren't sure, tax software can run your taxes both ways to determine which is better for you. Even an accountant can help you determine whether or not you should itemize.

Types of Tax Deductions

Keep in mind, amounts and rules can change. Be sure to stay up to date using the IRS Deductions for Individuals page.

Work Related Deductions:

  • Home Office DeductionIf part of your home is used for business purposes, such as an office, you may be able to deduct expenses for business use of your home. Both homeowners and renters can use this deduction, and it applies to every type of home. You have two ways to calculate this deduction. The simplest method is to deduct $5 per square foot of your office space, with 300 square feet being the max. The second method requires you to keep track of your household expenses. The amount of your deduction is based off of the percentage of your home that is designated for business. More in-depth information is available on irs.gov.

Education Deductions:

Investment Related Deductions:

  • Sale of Home - If certain conditions are met, you can exclude up to the first $250,000 of gain from the sale of your house from your income, so you don't have to pay taxes on it. A married couple filing jointly will see an increase to $500,000
  • Individual Retirement Arrangements (IRA) - Firstly, the amount of this deduction depends on whether you or your spouse has a retirement play through their place of work, and how much you make. If you qualify, you may deduct contributions to a traditional IRA.
  • Capital Losses - This deduction allows you to claim losses on investments. You use Schedule D of your 1040 tax return. There you can calculate and claim your capital loss deduction. This is a great tax break if you happened to have had a bad investment.

Itemized Deductions:

  • Charitable Contributions - If you donated charitable gifts such as cash, property or a car, you may be able to subtract the value of the donation(s) from you taxable income.
  • Medical and Dental Expenses -You can deduct qualified unreimbursed medical expenses that are more than 7.5% of your AGI for the tax year.
  • Health Savings Account (HSA) - If you contributed to a Health Savings Account, this is tax deductible. Also, withdrawals are tax free, as long as they are used on medical expenses. In 2020, if you have high-deductible health coverage for yourself, you can contribute up to $3,550. You have a high deductible coverage for you and your family, you can contribute up to $7,100.
  • Mortgage Interest Deduction - Tax payers can deduct interest on their mortgage up to the first $750,000. Investment property mortgages are not eligible. However, taxable rental income can still be reduced by the deduction. Home equity debt is not eligible if it was incurred for any other reason than making home improvements.
  • State and Local Tax (SALT) Deduction - Two components exist when it comes to the SALT deduction. First: Property Taxes -  If you paid taxes on personal property such as real estate or a car for instance, you can include it as part of the SALT deduction. Second: State Taxes - You can deduct your state and local income taxes or state and local sales taxes. Choosing state and income tax deduction is more beneficial, in most cases. 

The major change made to SALT by the new tax law is that the entire deduction has been capped at $10,000 per return, and $5,000 for married couples who are filing separately. For example, if you paid $7,000 in state income taxes and $5,000 in property taxes, your SALT deduction is $10,000. This doesn't cover the $12,000 you actually paid.

  • Gambling Loss Deduction - Gambling losses and expenses apply to the extent of winnings. So this doesn’t apply unless you win, and you can’t deduct more than what you’ve won.
 

Types of Tax Credits

  • Earned Income Tax Credit - Depending on how many kids you have, your marital status, and how much you make, this credit can get you $529 and $6,600. If your AGI is less than $57,000, this credit is worth checking out.
  • American Opportunity Tax Credit - This credit allows you to claim the first $2,000 spent on tuition, books, equipment and school feels. Living expenses aren't included, neither is transportation. You get 25% off of the next $2,000. 
  • Lifetime Learning Credit - With this credit, you can claim 20% of the first $10,000 you paid toward tuition and fees. The maximum is set at $2,000. It too, doesn't count living and transportation. You can claim books and supplies though.
  • Child and Dependent Care Tax Credit - This credit allows you to claim 20% to 35% of day care and related costs, up to $3,000. This is for a child under the age of 13, an incapacitated spouse or parent, an any other eligible dependent. Also if there are two or more dependents, you can claim up to $6,000.
  • Child Tax Credit - You get up to $2,000 per child and $500 for a non-child dependent.
  • Adoption Credit -This credit covers up to $14,080 in adoption costs per child.
  • Saver’s Credit - Depending on your filing status and income, this credit runs 10% to 50% of up to $2,0000 in contributions to an IRA, 401(k), 403(b) or other retirement plans. It's $4,000 if you're filing jointly.  
  • Residential Energy Credit - You can get up to 30% of the installation cost of a solar energy system. This includes solar water heaters and solar panels.