Michael Lodge - listen to my PodCast
Lodge & Co. www.lodge-co.com
Offices: Burbank, CA & Greenville, SC
Many of you come into the office to have your tax return done but have no idea what the difference is between credits, deductions and exemptions. You sit there and go with the flow. But let's talk about what they are so you understand what your tax accountant is talking about.
TAX EXEMPTIONS - So let's start at the top of the tax return where you mark the boxes that say who is being reported on your tax return, we call these above the line deduction. The boxes you check are personal tax exemptions that let you write off certain amounts per eligible person(s) in your household. For 2017 you are allowed to claim a personal tax exemption of $4,050 apiece for yourself, spouse (if married filing jointly) and dependent kids, and other dependents. In 2018 the standard deduction is being doubled, personal exemptions are being eliminated.
TAX DEDUCTIONS: This really confuses a lot of individuals because they just don't understand how it works. A tax exemption and deduction reduce your taxable income. Don't look at it as a reduction in your tax liability, however it does help you reduce taxable income. If the amount of your tax deduction is high enough it is possible to lower your income enough to drop into a much lower tax bracket. That is your goal by using the tax code to your advantage.
You have to look at tax deductions that are claimed before the calculation of your adjusted gross income and some deductions claimed after the calculation of your adjusted gross income. Confused? A good example of before the calculation would be IRA contributions, moving expenses, etc.
Now if you itemize your deductions your taxes rather than taking a standard deduction (30% of taxpayers), you can take additional below the adjusted gross income deductions against expenses like your state and local income tax, mortgage interest, and charitable donations. We call that below the line, below the adjusted gross income. I know what your thinking, could Congress make it anymore complicated? Well, that is what they do. However, here is the key. The tax code is there to help you reduce your tax liability, if you don't use it then you loose it.
TAX CREDITS: So we have talked about exemptions and deductions, well tax credits work a little differently. A credit reduces the taxes that you owe. How are you eligible? You can be eligible for these credits even if you don't itemize and just go with the standard deduction. People can miss deductions and credits because they don't realize all of the tax breaks available to them, they don't understand how the tax code can work for them. So the credits they can get go unclaimed and unused. Now here is what goes wrong, a lot of people think they are under the income filing threshold, but they could be very eligible for that credit and eligible for a refund for federal taxes taken out of their paycheck. That is because the EITC is what is known as a refundable credit. Nonrefundable credits can knock your tax bill way down to zero, but refundable credits, as the name implies, can have the government owing you.
Now let me talk about something that happens about every single day when dealing with tax clients. A lot of people who have paid into the system think that if they bring in every single expense that they can deduct them against their taxes. It doesn't work that way, there are limitations that you have to follow and the tax code is very specific on the type of deduction you can take. I had a single taxpayer come into the office where she had only contributed $46 to the federal tax system. But she thought that she had a pile of deductions she could take that would give her a big refund. But, she only paid in $46. And she was single. So think before you do things, talk with your tax accountant before you put too much effort into something that isn't there for you.
So this may have confused you more, work with your tax accountant.