Tax Credits and Deductions
When you file your income taxes, you can “write off” certain expenses, and get extra tax credits based on your living situation. This means that if you had a qualifying expense over the course of the year, you basically get to subtract that expense from the income you report to the IRS, which will increase your tax return (or at least lower how much you owe).
Claiming these credits and deductions can be tricky. Many people miss out on them simply by not knowing they exist or how to claim them.
Deductions VS Credits
There are two ways to reduce your tax bill, as a “Deduction” or as a “Tax Credit”.
A “Deduction” means you can subtract this amount from your total taxable income, so it will then lower your taxes owed or increase your refund.
A “Tax Credit” is an amount subtracted from the amount of tax you are owed. There are also two types of Tax Credits:
- Refundable – if you already owe zero tax, claiming a refundable tax credit means you will get a tax return for that amount.
- Non-Refundable – These can reduce your total tax burden to zero, but if it goes lower you won’t get the excess as an extra tax return.
When you pay an income tax directly from your paycheck, your W-2 form will show how much tax has already been paid. By claiming only “Deductions” and “Non-refundable tax credits”, the most you could get back on your tax return is that full amount. If you also can claim “Refundable” tax credits, you could end up getting back a return for more than the total taxes you pay.
Think of it this way, with a Tax Deduction the government is saying “that income doesn’t count, so we will not tax you on it”, while a Tax Credit says “we are going to reduce your tax bill by this amount”. If you have a 20% income tax, this means that a $1,000 tax deduction would lower your tax bill by $200, but a $1000 tax credit would reduce it by a full $1000.
Tax Deductions
Tax Deductions are also called “Write-offs” because you write these off your total income before your tax is calculated. A “tax deduction” is something written into the tax code where the lawmakers said, “What you spent here is the exact kind of stuff we want to encourage. So we’re not going to tax you on it”.
Deductions are usually paired to specific things you spend money on that you need to show proof of (like receipts) in order to receive the deduction. If you have an expense that you think might be tax-deductible, it is extremely important to keep detailed records. This includes receipts, documentation on why the expense was required (like a contract or even a letter from an employer), and these records should be kept in a single place for easy reference (like a folder on your desk for later reference).
These are the most common types of tax deductions:
The Standard Deduction
To make it easier to file taxes, everyone has the option to choose between “Itemized Deductions” or “Standard Deduction”. If you file an “Itemized Deduction”, you need to provide evidence of each item you’re deducting (like receipts and proof it is eligible), which can be very time-consuming for small deductions.
Alternatively, if you don’t think you have very much to deduct, you can just claim the “Standard Deduction”, which is a flat $12,400 per person. If you take the Standard Deduction, you get it without having to provide any evidence of anything. Young people with lower incomes and no dependents generally find that their Standard Deduction is bigger than their itemized deduction, and is much easier to work with.
If you do take the standardized deduction, you can still claim other tax credits, but no other deductions. See the IRS page on the Standard Deduction. For the vast majority of people, taking the “Standard Deduction” is a better deal anyway than an itemized deduction, so you save a lot of time and effort, plus you get a lower tax bill. Everybody wins!
Dependents and Children
We will talk more about child tax credits later, but if you are in high school or just about to start your career, you might still be considered a dependent by your parents. What this means is that you do not get the full “standard deduction”. If you are still a dependent, your standard deduction goes down to just $1,100.
Click here to see the IRS page on Dependents.
Work Related
If you need to spend your own money because of your job, this is also usually tax-deductible. For work-related expenses, the key is that you MUST spend the money as part of your job.
Job Moving Expense
While you cannot write off any costs incurred in a job search, if you need to move between cities when you get a job, you can usually write off part of the moving expense. This is a deduction, subtracted from your taxable income. Click Here for more information about deducting moving expenses.
Work Equipment
If you need to purchase a uniform or other work-related equipment for your job, you can also write off these expenses. This is a big deal if you are a contractor or self-employed. You may even be able to write off some of your rent, utilities, and other expenses if you work from home. Click here to learn more about work expense write-offs.
However, it is important that you MUST spend this specific money for your job. For example, if your job requires a standard uniform this would be a tax-deductible expense. If instead you work in an office, and you just need to have “business clothes” to match a company dress code, this would NOT be tax-deductible. The famous band from the 1970’s ABBA is a great example of this – their stage costumes were extremely flashy and flamboyant, which they successfully argued meant that they were solely a business expense, and could deduct the costume cost from their income because they were useless outside of work.
Car Mileage
If you need to use your own personal vehicle for work, you can also claim a tax deduction based on how far you need to drive. Instead of collecting gas receipts, the IRS gives a set per-mile deduction, which changes every year (currently around 50-60 cents per mile). This deduction is to cover both the gas used when driving and the “wear and tear” on your vehicle.
This only counts if you need to use your car DURING work. You cannot claim any tax deductions for commuting to and from your job.
Student Loan Interest
You can write off up to $2500 of interest on your student loans per year. This works as a deduction, so this amount is simply subtracted from your taxable income. Note that if your parents help with your student loan payments, you can still claim what they pay on your taxes. Click Here for more information about the Student Loan Interest Deduction.
Investment Losses
Your investment portfolio has been doing terribly this year. All of your stop orders were triggered, and you finished the year with a $1000 loss. The silver lining is that this is tax-deductible – and unlike some of the other items on this list, you can write off your investment losses even if you claimed the standard deduction! Do not go overboard with your losses though – you can only write off up to $3000 in losses each year.
Tax Credits
Tax Credits are easier to work with than deductions – you typically just need to prove that you qualify, instead of providing receipts or other documentation. There is also no “standard credit” every person should try to get any tax credits they qualify for because each one comes directly off your tax bill.
Child Tax Credits
The most common tax credits involve families with dependents or children. In order to qualify as your dependent, a person must:
- Be under 18 (17 or 19, for some tax breaks) years old
- Be related to you
- Have lived with you for more than half of the last year
- Not be claimed by someone else as their dependent
As the parent or guardian, you get up to $3000 in tax credits per year per child to help offset the costs of parenting.
The Child Dependent Care Tax Credit
This tax credit was created to offset the cost of daycare and child care. You can deduct between 20% and 30% of any child care expenses under $6000 per child (no tax breaks on costs over $6000). Unlike the other child tax credits, this one only applies to children 13 or younger. This also does require documentation that you spent this money on child care. The tax credit can only be applied to a certain percentage of money actually spent on child care.
Click Here for the IRS FAQ for the Child Dependent Care Tax Credit.
Earned Income Tax Credit
The Earned Income Tax Credit (EITC) is a national program to help raise low and middle-income workers out of poverty, specifically targeting families. It is a refundable tax credit.
While you do not necessarily need to have dependents to claim the EITC, you will get a lot more out of it if you do.
The EITC works by helping people with low income – this means you need to have worked and earned some income for the previous year. The EITC you might be eligible for is shaped like an n – you get very little if you earned very little, then rises with your income to a certain point before tapering off as your income continues to rise.
This is because the EITC is designed to encourage people to be working and earning a wage. For people with very little income from working, the EITC gives very little because it works under the assumption that they are earning other benefits, such as food stamps and housing assistance. It rises in the middle to help the working poor escape poverty while tapering off as income continues to rise in order to reduce the benefits received by people who no longer require the assistance.
Your EITC goes up significantly if you claim dependents. In 2016 the most you could get with no children was just over $500 while having two children increased the amount to over $5,500.
Click Here to see the IRS page for the Earned Income Tax Credit.
Home Ownership
There are also many tax credits available to help offset the cost of renovations you do to your house if those renovations help it become more energy efficient. These credits were put in place to help homeowners upgrade old insulation and windows, reducing the total energy cost to keep the house warm in the winter and cool in the summer. The tax credit is typically for around 10% of the purchase cost, but this can vary year to year. Click Here for more information about energy efficiency tax credits.
Bigger energy credits are available if you add green energy equipment to your house, like solar panels or residential wind turbines. These credits are typically for about 30% of the purchase cost.
Education
There are several major tax credits if you attend college, or get extra work training. These are in place to encourage people to keep building more valuable work skills.
American Opportunity Tax Credit
The American Opportunity Tax Credit gives credit for the first $2500 in education expenses per year, but you need to be enrolled in an accredited university in the United States, and be pursuing a degree. You can only claim this credit for 4 total years, and you must be enrolled for at least one full session in the year you claim it. You will need to provide your tuition bills and documentation from your school to show that you qualify.
This is a semi-refundable tax credit – if your tax burden is already zero, 40% (or up to $1000) is refundable. Click Here for the IRS page on the American Opportunity Tax Credit.
Lifetime Learning Tax Credit
The Lifetime Learning Tax Credit is very similar to the American Opportunity credit, but with a lower threshold – only up to $2000, and is not refundable. You will still need to show your tuition bills and evidence from your university to qualify. Most schools have a dedicated tax form that you can download with all the relevant information to send to the IRS.
The upside is that you can claim it as many times as you like, and do not need to be enrolled in a degree program (so it also applies to extra courses and skill-building programs). Both the Lifetime Learning and American Opportunity tax credits have income thresholds – as your income goes up, your tax credit will be reduced. Click Here to learn more about the Lifetime Learning Tax Credit.
Insurance and Investments
There are also many breaks you can get for some insurance and investment costs, designed to help offset these costs for lower-income workers.
Advanced Premium Tax Credit
If you purchased health insurance through the healthcare.gov exchange, you can claim some of your premiums as a tax credit. The actual amount you can claim will vary greatly based on your income and premiums, but the credit is also refundable. Click Here for the IRS FAQ for the Advanced Premium Tax Credit.
Saver’s Credit
The “Saver’s Credit” is another word for the Retirement Savings Contribution Credit. The purpose of this credit is to encourage saving in retirement accounts and IRAs. This credit is for up to $2000 and is calculated as a percentage of your contributions (either 50%, 20%, or 10%, depending on your income). Click Here for the IRS information on the Saver’s Credit.