Beginner’s Guide to Tax Deductions and Credits

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In our previous article we introduced income tax regulations for individuals. In this article we will continue with the tax theme and look at some major tax deductions and credits which lower your tax bill if you qualify for them.

Deductions reduce taxable income while tax credits reduce taxes dollar-for-dollar, and are more valuable than tax deductions.

PART I: TAX DEDUCTIONS

There are two main types of deductions: the standard deduction and itemized deductions. You can choose whichever method gives you the larger deduction.

STANDARD DEDUCTIONS

The amount for standard deduction is set by the IRS and varies based on filing status. For 2023, standard deductions are as follows:

1. Single or Married Filing Separately: $14,600

2. Married Filing Jointly or Qualifying Widow(er): $29,200

3. Head of Household:: $21,900

For individuals older than 65 or are blind, there are additional amounts allowed for the standard deduction as follows:

Single or head of household

65 or older or blind $1,950

65 or older and blind $3,900

Married filing jointly or separately and surviving spouse

65 or older or blind $1,550 (per qualifying person)

65 or older and blind $3,100 (per qualifying person)

ITEMIZED DEDUCTIONS

If a taxpayer’s eligible expenses exceed the standard deduction, the taxpayer might benefit from itemizing deductions. Itemized deductions are certain expenses the IRS allows taxpayers to deduct in lieu of the standard deduction. Some of the main itemized deductions are as follows:

a) Medical and Dental Expenses

Taxpayers can deduct the amount exceeding 7.5% of Adjusted Gross Income (AGI). It includes:

a) Expenses for diagnosis, treatment, prevention, and transportation for medical care

b) Payments to doctors, dentists, surgeons, and other medical practitioners

c) Prescription medications and insulin

d) Medical equipment and supplies

e) Health insurance premiums (if not paid with pre-tax dollars)

b) State and Local Taxes (SALT)

Taxpayers can deduct state and local income, sales, and property taxes. The deduction is limited to $10,000 per return ($5,000 if married filing separately)

c) Mortgage Interest

Mortgage interest paid for a primary residence and a second home is deductible. It includes interest on home equity loans and lines of credit, if the funds were used to buy, build, or improve the home.

Interest is allowed on up to $750,000 of mortgage debt ($375,000 if married filing separately). For mortgages taken out before December 16, 2017, the limit is $1 million.

d) Charitable Contributions

Taxpayers can deduct contributions to qualified charitable organizations. This includes cash donations, non-cash contributions (e.g., clothing, household items), and miles driven for charitable purposes.

Charitable contributions are generally limited to 60% of AGI for cash contributions and 30% for non-cash contributions. Taxpayers should keep good records, especially for donations of $250 or more, in case they are audited by the IRS.

e) Casualty and Theft Losses

Casualty and theft losses are allowed only in federally declared disaster areas. In order to claim the deduction, losses must exceed $100 per incident and 10% of AGI. It includes damage to home, vehicles, or personal property and losses from theft.

ABOVE-THE-LINE DEDUCTIONS

Above-the-line deductions reduce adjusted gross income and can be taken even if the taxpayer does not itemize deductions. Key above-the-line deductions include:

a) Educator Expenses

Educators can claim up to $300 of unreimbursed expenses for classroom supplies and professional development courses for K-12 educators, teachers, counselors, principals, or aides.

b) Health Savings Account (HSA) Contributions

Taxpayers can deduct contributions to an HSA if they have a high-deductible health plan (HDHP). Contribution limits for 2024 are $4,150 for individual coverage and $8,300 for family coverage. An additional $1,000 catch-up contribution is allowed for those age 55 or older.

c) Self-Employed Health Insurance Premiums

Self-employed taxpayers can deduct 100% of health, dental, and long-term care insurance premiums.

d) Alimony Payments

Alimony payments are deductible for divorce agreements executed before 2019.

e) Student Loan Interest

Taxpayers can deduct up to $2,500 of interest paid on qualified student loans. The deduction phases out at higher income levels.

f) Retirement Contributions

Taxpayers can deduct up to $7,000 ($8,000 if 50 or older) for contributions to traditional or ROTH Individual Retirement Accounts (IRA). The amount that can be deducted depends on income and whether the taxpayer is covered by a workplace retirement plan.

For self-employed individuals, contributions to self-employed retirement plans are deductible, subject to limits. Self-employed retirement plans include Simplified Employee Pension (SEP) IRAs, Savings Incentive Match Plan for Employees (SIMPLE ) IRAs, and solo 401(k) plans.

SELF-EMPLOYED TAX DEDUCTIONS

Self-employed individuals can deduct many business expenses, including:

Home office expenses

1. You must use a portion of your home exclusively and regularly for business in order to claim this deduction.
2. The deduction is based on the percentage of the home used for business (typically based on square footage) times expenses spent on the home for the year. Deductible expenses include mortgage interest, property taxes, utilities, repairs, insurance and other expenses incurred for the home.
3. For example, if 500 square feet of a 2,000 square foot home is used for business, 25% (500/2,000) of all expenses for the home can be deducted.
4. Taxpayers may use a simplified method ($5 per square foot, up to 300 square feet) or the actual expense method described above.

Vehicle expenses

Self-employed taxpayers can deduct actual expenses spent on vehicles used for business, or use a standard mileage rate of $0.67 per mile for 2024.

Self-Employment Tax Deduction

Self-employed individuals pay self-employment tax on their business income. Half of this self-employment tax can be deducted.

Qualified Business Income Deduction

Business owners are allowed a deduction of up to 20% of their qualified business income, subject to certain eligibility rules.

OTHER NOTABLE DEDUCTIONS

a) Moving Expenses

Moving expenses are only allowed for active-duty military members moving due to military orders.

b) Gambling Losses

Taxpayers may deduct up to the amount of their gambling winnings. Taxpayers should keep thorough records of all expenses they plan to deduct. This includes:

Receipts

Canceled checks

Credit card statements

Vehicle mileage logs

Acknowledgment letters from charities

INCOME PHASEOUTS

Many deductions phase out at higher income levels. Taxpayers should be aware of these limitations for their specific situation.

PART II: TAX CREDITS

Tax credits directly reduce the amount a taxpayer owes, dollar for dollar, and is therefore more valuable than tax deductions. The benefit from a tax deduction depends on a taxpayer’s tax rate. For example, a taxpayer with a tax rate of 15% would save $15 in taxes for a $100 deduction. A tax credit of $100 would save the taxpayer $100 in a similar situation.

Below is a dozen of the most popular tax credits.

1. EARNED INCOME TAX CREDIT (EITC)

The Earned Income Credit (EITC), is probably the most popular and most abused tax credit. The EITC is a credit for low-to-moderate-income working individuals and families. The credit amount varies based on income and number of dependents.

Taxpayers must meet the following requirements to qualify for the EITC:

a) Have worked and earned income under $63,398.

b) Have investment income below $11,000 for the tax year.

c) Have a valid Social Security number.

d) Be a U.S. citizen or a resident alien all year.

e) Not file Form 2555, Foreign Earned Income.

f) Meet certain rules if separated from spouse and not filing a joint tax return.

For 2024 the maximum for the EITC is as follows:

1. No children: $632
2. 1 child: $4,213
3. 2 children: $6,960
4. 3+ children: $7,830

CHILD TAX CREDIT

The child tax credit is paid to individuals with qualifying dependent children. A qualifying child must be under 17 years of age at the end of the tax year, have a valid Social Security number, and must be a U.S. citizen, U.S. national or U.S. resident alien. There are other eligibility requirements.

The child tax credit allowed for 2024 is as follows:

1. Up to $2,000 per qualifying child under 17
2. Up to $1,700 of that is refundable. This means that if the credit reduces the tax owed to zero, the taxpayer can still get back up to $1,700 as a refund.
3. The credit begins to phase out at $200,000 AGI ($400,000 for married filing jointly)

CHILD AND DEPENDENT CARE CREDIT

The Child and Dependent Care Credit helps offset the cost of care for children under age 13 or for a spouse or dependent who is unable to care for themselves.

The amount allowed is as follows:

1. Up to 35% of $3,000 in qualifying expenses for one child/dependent
2. Up to 35% of $6,000 for two or more children/dependents
3. The percentage reduces as income increases

AMERICAN OPPORTUNITY TAX CREDIT

This credit is available for qualified education expenses for the first four years of higher education.

The credit is as follows:

1. For college expenses, up to $2,500 per eligible student
2. Forty percent is refundable (up to $1,000)
3. It phases out between $80,000-$90,000 AGI ($160,000-$180,000 for married filing jointly)

LIFETIME LEARNING CREDIT

This credit applies to qualified tuition and related expenses and is for all years of post-secondary education and for courses to acquire or improve job skills. The maximum credit is $2,000 per tax return.

The credit phases out between $80,000-$90,000 AGI ($160,000-$180,000 for married filing jointly).

RETIREMENT SAVINGS CONTRIBUTIONS CREDIT (SAVER’S CREDIT)

The Saver’s Credit is available to low and moderate income taxpayers who contribute to a retirement plan, such as a 401(k) or IRA. The credit is up to 50% of contributions to retirement accounts.

The maximum credit is $1,000 ($2,000 if married filing jointly), and the percentage decreases as income increases.

ADOPTION CREDIT

This credit includes both a credit for qualified adoption expenses paid to adopt an eligible child and an exclusion from income for employer-provided adoption assistance.

Qualifying adoption credit expenses include:

1. Reasonable and necessary adoption fees
2. Court costs and attorney fees
3. Traveling expenses (including amounts spent for meals and lodging while away from home), and
4. Other expenses that are directly related to and for the principal purpose of the legal adoption of an eligible child.

An eligible child is an individual who is under the age of 18 or is physically or mentally incapable of self-care. The credit is up to $16,810 per child and it phases out for higher incomes.

PREMIUM TAX CREDIT

This helps to cover premiums for Health Insurance Marketplace (Obamacare) plans. The amount allowed varies based on income and plan cost.

RESIDENTIAL CLEAN ENERGY CREDIT

Thirty percent of the cost of eligible solar, wind, geothermal, and biomass fuel property is allowed as a tax credit.

ELECTRIC VEHICLE CREDIT

Up to $7,500 is allowed for new electric vehicles purchased, and up to $4,000 is allowed for used electric vehicles. The credit is subject to income limits and vehicle price caps.

ENERGY EFFICIENT HOME IMPROVEMENT CREDIT

Thirty percent of costs for eligible energy-saving improvements is allowed as a tax credit. An annual limit of $1,200 is allowed for most improvements.

FOREIGN TAX CREDIT

This credit is allowed for taxes paid to foreign countries. It is limited to the U.S. tax on foreign income.

Part III: IMPORTANT CONSIDERATIONS FOR TAX CREDITS

Income Limitations

Many tax credits phase out at higher income levels.

Refundable vs. Non-refundable

Refundable credits can result in a refund even if they exceed the taxpayer’s tax liability. Non-refundable credits can only reduce your tax liability to zero.

Recordkeeping

Taxpayers should maintain thorough records for all deductions and credits claimed.

Tax Law Changes

Taxpayers should stay informed about potential changes to tax laws that may affect deductions and credits.

State-Specific Benefits

States have their own tax rules for additional deductions and credits. Taxpayers should be aware of state deductions and credits.

Professional Advice

Taxpayers should consult with a tax professional for complex situations or to ensure they are maximizing their tax benefits.

Understanding available tax deductions and credits is important for minimizing your tax liability and or increasing your refund. Tax laws are complex and subject to change. You should always verify current tax laws and seek professional help for your specific situation.

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This article is for informational purposes only and should not be considered legal or tax advice. Always consult with a qualified tax professional for personalized guidance.