- Learn about itemized tax deductions.
- Discover common above-the-line tax deductions.
- Find out why we distinguish between above-the-line and below-the-line tax deductions.
- Learn about common business deductions.
- Find out why good recordkeeping is so important in asset-sale deductions.
- Discover some of the most common refundable tax credits.
- What happens to a nonrefundable credit if you do not use it all the first year?
- Find out how carryover credits work.
- What happens if your business tax credits exceed your tax?
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. Fiducial explains these terms for you below. In general, a deduction reduces taxable income, whereas a credit reduces the tax itself.
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:
When taxpayers think of deductions, they typically think of the itemized deductions that are claimed on Schedule A. This is the only way to deduct personal expenses such as medical costs, state and local tax payments, investment and home-mortgage interest, charitable contributions (in most years), disaster-casualty losses, and various rarely encountered expenses.
In some cases, limitations exist on itemized deductions. For instance, medical expenses are only deductible to the extent they exceed 7.5% of the taxpayer’s adjusted gross income (AGI). Similarly, state and local tax payments (including those for income, sales, and property taxes) have a cap of $10,000. However, pending legislation may increase or eliminate that limitation.
In addition, for tax years 2018-2025, taxpayers cannot claim miscellaneous itemized deductions subject to the 2% of AGI limitation. Nondeductible expenses include investment fees, legal fees, tax preparation fees, union dues, work-related education expenses, and unreimbursed employee business expenses.
On top of all of this, itemization only reduces taxable income to the extent that the total of the itemized deductions exceeds the standard deduction. When the sum does not exceed the standard deduction, the itemized deductible expenses provide no tax benefits at all.
Certain deductions actually reduce income. We commonly refer to these as above-the-line deductions because, when applied, they reduce the income figure 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).
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.
Example: In 2021 Liz, who is single, has a wage income of $50,000 and made a contribution to her traditional IRA of $3,000. She also contributed $300 to the Red Cross and is not itemizing deductions. Her AGI is $47,000 ($50,000 – $3,000), and her taxable income is $34,150 (AGI $47,000 – $300 donation – standard deduction for a single person of $12,550). Her income tax is based on her taxable income of $34,150.
Another below-the-line deduction is the Section 199A qualified business income deduction which 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? We use AGI 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.
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.
An individual who sells an asset may deduct that asset’s cost from the sale price to determine the taxable profit. It helps to keep good records 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 come in several varieties, and the amount of benefit can vary:
A refundable credit first offsets current tax liability. If any credit remains after applying it to the tax, the taxpayer receives the difference in a refund. Hence, the term refundable credit. Refundable tax credits include the Earned Income Tax Credit, the Child Tax Credit, and the Premium Tax Credit (net of any advances received), as well as the American Opportunity Tax Credit (an education credit that is 40% refundable up to $1,000). As a matter of general interest, these tax credits are subject to significant filing fraud because of their refundability. The IRS also considers prepayments such as income-tax withholding and estimated tax payments as refundable credits.
A nonrefundable credit only offsets tax liability; taxpayers lose any unused amount (unless they can carry it over to another year; see below). Over time, Congress has become more generous with tax credits; most credits that are not refundable now carry over for a given period. Nonrefundable tax credits include the Saver’s Credit, the Lifetime Learning Credit, and the Child and Dependent Care Credit.
For some nonrefundable tax credits, any unused current-year credit may carry over to the next tax year (or for a longer period) until the carryover amount is used up. These tax credits include the Adoption Credit (which can carry over for up to five years) and the Home-Solar Credit.
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.)