By Kedra Williams
NDG special contributor
As we prepare for the 2010 filing process, it is always a good idea to review your expenditures from last year for every single tax saving available to you. In recent years, as the economy has pushed most of us to make some difficult decisions about finances, the legislature has provided some additional credits and offsets that would be beneficial to know as you sit down with your tax professional.
First and foremost, it is important to understand the difference between tax deductions and tax credits. While both deductions and credits typically reduce your tax liability, the way they impact your return and your pocket book can be quite different. Tax deductions are the various items that are available to reduce the income on which you are taxed. For instance, mortgage interest, job search expenditures, personal exemptions, student loan interest are all items that are deducted from your gross income to determine your taxable income. The tax you pay is determined by multiplying your applicable tax rate to your taxable income. Given the option of $400 in tax deductions or $400 in tax credits, which would you choose?
To illustrate the difference between tax deduction and tax credits, consider the following:
Let’s say, your gross income is $1,000 and your total tax deductions are $400 leaving a taxable income of $600. Assuming a tax rate of 10%, your total tax due is $60. The net tax savings from your deductions is $40 (10% times your deductions).
Now a tax credit, on the other hand, is a dollar for dollar reduction of the actual tax you pay, not taxable income. This in most cases is significant for taxpayers. So continuing in our simplistic example, instead of deductions of $400 you have $400 in tax credits. Without deductions (for simplicity), your taxable income would be the same as your gross income, $1,000. Assuming the same 10% tax rate, your calculated tax before credits will be $100. However, you owe no tax because your credits will exceed your entire tax liability. After applying $100 tax credit, you will still have $300 remaining in credit.
In some instances this difference is actually refundable to you. So not only do you not owe any taxes, you actually will get a check from the IRS for $300 remaining credit. Refundable credits you may have heard of are Earned Income Credit, Child Tax Credit, First Time Homebuyer’s Credit and others.
Even in the case of nonrefundable credits, in this scenario you would pay no taxes using the credit (versus $60 using the same dollar amount of deductions).
While this example is extremely simplified, it makes clear why tax credits are a political hot spot no matter which side you’re on.
Some of the top credits highlighted for this season are:
Small Employer Health Insurance Credit – Certain employers who pay health insurance premiums for their employees may receive up to 35% of the premiums paid as a credit against their tax liability.
American Opportunity Credit – Taxpayers paying education expenses may receive up to $2,500 credit on the first four years of qualified higher education expenses per student (100% of first $2,000 spent and 25% of next $2,000).
Lifetime Learning Credit – Taxpayers pursuing continuing education may receive up to $2,000 credit for post-secondary education and courses to acquire or improve job skills. (20% of first $10K).
Personal Energy Property Credit – Homeowners who install certain energy saving improvements such as insulation, doors, windows, heat pumps etc, can take a credit of 30% of their cost (up to 2009-2010 aggregate limit $1500).
First Time Homebuyer Credit – The much publicized credit for new home buyer’s up to $8,000 for first-time buyer’s and up to $6,500 for long-term residents purchasing new principal residences.
While many taxpayers are familiar with the common tax deductions, the credits are sometimes best known by those who invest in professional tax advisers. It is always prudent to refer to the applicable laws, requirements and qualifications before taking these credits on your tax return.
Information about current tax credits and deductions is available online at www.irs.gov, through your professional tax adviser, or you may contact us for further assistance.
Kedra A. Williams CPA PC, 3940 St. Francis Ave. Suite 103, Dallas, TX 75228. Her firm specializes in complex tax issues and IRS negotiations call us at 469-449-9833 and visit us online at www.kedrawilliams.com.
