Deductions and Credits | Incite Tax

All right everyone, today we're going to talk about deductions and credits. So I'm going to teach you the differences, go over some examples, and then we'll talk about how they affect your tax return. Let's get into it. As a broad overview, deductions are going to lower your taxable income while credits are going to lower your actual tax liability. So in practice, how this works is deductions are going to save you money at your tax rate while credits are going to lower your tax dollar for dollar. That sounds a little confusing. Don't worry, I'm going to go over the math a little bit later in the video. So what is a deduction? A tax deduction is an expense that lowers the income of your return. So for a business, this is going to be synonymous with the term expense. Some common business expenses or deductions are office supplies, advertising, credit card interest, legal fees, licenses, or business meals and travel. Really any operating expense that you have that's ordinary, reasonable, and necessary, the IRS says, you can take as an expense on your return or deduction for your business. And these are going to, like I said, lower your income. But I'm sure some of you have heard of other deductions like the standard deduction or itemized deductions. And those work in a similar way. They're going to lower your taxable income, so you can use either the standard deduction or the itemized deduction in addition to any business deductions that you have on your return that'll lower your income. Most taxpayers are going to use the standard deduction, but if your itemized deductions are higher than the standard deduction, we will optimize that for you when we prepare your tax return. So some common itemized deductions include medical expenses, state income taxes, real estate taxes on your primary residence, mortgage interest, and your charitable donations. So how do these deductions affect your tax return? I have a couple scenarios here that are going to kind of demonstrate the math of what I'm talking about. So in scenario 1, say you have income of $100,000 and business deductions of $10,000. That means you're going to be taxed on the difference. This $100,000 minus this $10,000, you're only taxed on $90,000 of it, the profit. Say you're in the 20% tax bracket. This $90,000 times 20% means you're going to have a tax due of $18,000. But say in scenario 2 here that instead of spending $10,000, we spend $50,000. So we have $40,000 more in expenses. So we're only taxed on $50,000 at the 20% bracket, this is going to be $10,000 in taxes. Now notice here we spent $40,000, but our tax did not change by $40,000. This isn't creating a refund of $20,000 because we spent $40,000 more. Instead, it's only lowering our tax by $8,000, which you can see is that $40,000 times your tax rate. So the higher tax rate you're in, the better— the more deductions are going to save you. And that about sums it up for deductions. So now let's talk about credits. So what are some common examples of tax credits? Some common ones that you'll see are the Child Tax Credit, Child Dependent Care Credit, Education Credit, the Saver's Credit, Earned Income Tax Credit, and solar and EV credits. There's also 2 different types of credits, refundable and non-refundable. The difference here is that non-refundable credits are going to require a tax liability to use them. So this means you're going to need income on your return, either business income or W-2 income, that those non-refundable credits can offset. And I'll cover this more later in the video as well when we look at the tax return. So how do these affect your tax return? I have a couple more scenarios here. So say that you have income of $30,000. The standard deduction for a single filer was $13,850. So your taxable income this time is $16,150. Say you're in the 12% tax bracket, this is going to generate almost $2,000 of tax. So say you install some solar panels on your house, you get a solar credit of $10,000. This is a non-refundable credit, so you can see it's going to lower your tax liability down to zero, but it's not going to generate a refund. So even though you have an extra $8,000 of credit, that's going to get carried forward to a future year instead of generating a refund for you because it's a non-refundable credit. And then we have the same scenario here in Scenario 2, except for this time we have 2 kids of child tax credit, and this is, you can see, going to generate a refund because child tax credits are refundable. So rather than just reducing our tax liability to zero, the IRS will actually pay this out to you in the form of a refund. I hope that adds some clarity about the differences between deductions and credits. Now let's head over to the tax return and I can show you how it works on the forms. All right everyone, so this is the individual income tax return and I want to show you how deductions and credits are actually going to apply on the form. So down here, these first 8 lines is where all of your income is going to get added together. So whether that's W-2 income, interest income, dividend income, Income from a retirement account. Your business income will come to play here on line 8, and then all those are going to get totaled on line 9. This is going to be your total income. And now this is where deductions are going to come into play. So on line 10, you'll have any business losses, and then on line 12, you'll have any standard deduction or itemized deductions. Whichever one is higher will get subtracted from this line 9. So you have your total income. Then you'll have your total deductions. This is going to create your taxable income here on line 15, and this is the number that your tax is going to get based off. So this is going to determine your tax bracket and your tax liability. So you're going to have income all summed up, and then your deductions come into play here— business deductions and then those personal ones, either itemized or standard— is going to generate your tax. So deductions are all going to apply up here, or your taxable income, sorry, and then your tax is going to be generated here on line 16. This is going to come from your tax bracket in the table, this is going to be your tax due before credits right here. Then this is where any non-refundable credits are going to come into play. So say you have an $8,000 tax liability here, say you have a solar credit this year of $10,000, that'll come into play and it'll get capped here on line 22. You can see it's not going to generate a negative tax liability or a refund. So say you have $8,000 of tax liability, $10,000 tax credit. This isn't going to be a $2,000 tax refund. It's just going to lower your tax down to zero, and that's why it's not going to generate a refund for you, these non-refundable credits. So then this line 24 is going to be your tax after credits. So after those non-deductible ones are taken into account, you'll get line 24. This is where you'll have like any withholdings from W-2, and you can see those are treated similarly to these refundable credits like Earned Income Credit, Child Tax Credit, the refundable portion, these— an education credit, the refundable part of the American Opportunity Credit. So you'll have those refundable credits right here, and then if those are higher than your tax due after non-refundable credits, then that'll generate a refund down for you, down here for you at the bottom. So I hope that clears up some things about deductions and credits. Thanks for tuning in. And we'll see you in the next video.