Tax deductions and credits are usually referred to as the same by most people. They can make a significant financial impact and reduce the amount owed to the government, but they function in distinct ways. Learn the key differences—along with some effective strategies for keeping more money in your pocket this filing season.
What is the difference between a tax credit and a tax deduction?
A deduction lowers the total taxable earnings, ultimately reducing the amount owed for the year. The process follows a simple formula: calculate total income, subtract eligible deductions, and arrive at a lower taxable figure. The smaller this number, the lower the final obligation.
Credits, on the other hand, work differently. Instead of reducing taxable income, they directly lower the total amount owed, dollar for dollar. Some credits are even refundable, meaning if the credit surpasses the total due, an individual may receive a refund. For example, if an individual owes $1,000 but qualifies for a $2,000 credit, they will receive a $1,000 refund.
A credit typically provides a greater financial benefit than a deduction. However, understanding how both work and planning accordingly can significantly reduce financial obligations and prevent unexpected expenses.
Ways to Reduce Your Financial Liability in 2019 and 2020
Here are some tips that can help you be ready for your income tax and save some money in the years 2019 and 2020.
- Home office deduction
Self-employed individuals and freelancers often use this provision. The IRS allows the deduction of expenses related to the portion of a home used for work, including rent, utilities, property-related costs, furniture, repairs, and other necessary expenditures.
- Self-employment expenses deduction
This provision is crucial for independent professionals, contractors, and small business owners. Keeping accurate records of business-related expenditures throughout the year can lead to significant savings.
- Earned Income Tax Credit
This financial relief is based on household size, marital status, and yearly earnings. Eligible individuals could receive between $529 and $6,557 in 2019 and between $538 and $6,660 in 2020.
- Child tax credit
Designed to assist families, this benefit provides up to $2,000 per qualifying child and $500 for non-dependent children.
- Charitable donations deduction
Donations to recognized organizations—whether in the form of clothing, vehicles, monetary gifts, time, or property—can be deducted from taxable earnings, reducing financial liability.
- IRA contributions deduction
Contributions to traditional retirement accounts may be deductible. The amount depends on factors such as workplace-sponsored retirement plans and total income.
- 401(k) contributions deduction
Contributions deducted directly from a paycheck into a 401(k) can reduce taxable income. In 2019, individuals could contribute up to $19,000 per year, while those 50 and older could add up to $25,000. In 2020, these limits increased to $19,500 and $26,000, respectively. While these accounts are commonly offered by employers, self-employed individuals can establish their own.
- Mortgage interest deduction
This is especially beneficial for homeowners. It lowers federal obligations by allowing interest paid on a mortgage to be deducted from taxable income.
- Medical expenses deduction
With healthcare costs rising, this provision eases financial burdens by allowing qualified, unreimbursed medical expenses exceeding 10% of adjusted gross income to be deducted.
By strategically utilizing deductions and credits, individuals can significantly lower their financial liabilities and maximize savings. Understanding these provisions ensures a well-prepared and stress-free filing season.
Maximizing Benefits for a Stress-Free Filing Season
By strategically utilizing deductions and credits, individuals can significantly lower their financial obligations and maximize savings. Staying informed and planning accordingly ensures that no available benefit is overlooked. Organizing receipts, maintaining accurate records, and consulting financial professionals when necessary can make a substantial difference in reducing owed amounts and securing refunds.
Understanding these provisions enables better financial planning and minimizes surprises during filing season. Making informed decisions throughout the year ensures that more money stays in your pocket instead of being unnecessarily overpaid.
