Deduction vs Credit?
By Tim Frye
When it comes to taxes, most people cringe at the thought of trying to comprehend even it’s most miniscule aspects. Accountants get paid hefty fees an hour because of this fact. The tax code currently finishes off at an excess of 70,000 pages, so it’s no wonder people want nothing to do with it. Our job at Pronto Education is to aid you, the tax preparer, in transposing these intricacies into a tangible, understandable, and clear format. The true foundation of taxation is the usage of deductions and credits to reduce taxable income. It is important for you to be able to designate and elaborate on the difference between a deduction and a credit. Let us jump head first into the tax pool and test the waters…
Before we even go into the specifics and definitions of deductions and credits, lets establish the procedural aspects of taxation. When you sit down with your client, after your gathering of the requisite information like names and social security numbers, you will have to assist your client with the calculation of figuring gross income. Once you include all the types of income that are taxable, you can get to the good part. Deducting your client’s income before it will be taxed. Income is not taxed until it is reduced by the two main deductions that everyone gets, which are the standard deduction and the personal exemption. Remember this is a bare boned example of how you get to taxable income.
Deductions reduce a taxpayer’s taxable income. So once gross income is calculated, the deduction reduces the income before it is taxed. So there is where you have a chance to reduce income before it has the progressive tax rates applied to it. The first deduction given to the taxpayer is the Standard Deduction, or Itemized Deduction, if they qualify. The standard deduction is a concrete amount given to the taxpayer, and it’s exact number varies according to filing status. So, just to reiterate, deduction reduce the amount of money applicable for taxation.
After the two requisite deductions are applied against gross income, what’s left is the taxable portion, appropriately called taxable income. At this point, the progressive tax rates are applied to taxable income, and the rates climb accordingly. So, for more favorable filing statuses, like MFJ, the tax rates progressively climb slower and at later thresholds along taxable income. While the MFJ taxpayer is still in the 10% bracket, the single filer with the same amount of taxable income will be in the 15% bracket.
So after tax liability is calculated, credits are then levied against the tax owed. And credits go dollar for dollar towards the person’s tax debt, and if they are refundable they can actually give you money back after tax liability is reduced to zero.
Refundable credits are really the stuff the titanic refund is made of. The refundable credit, as stated previously, will give your client money back in their pocket after tax liability has bottomed out. The most famous and prevelant refundable credit is the Earned Income Credit. The EIC is an anti-povery credit that saw it’s germination in the 70s during Jimmy Carter’s presidential tenure. Then there is the Child Tax Credit. The EIC is at its most valuable point when the candidate is at poverty level and has two or more children. This is where you will see the $7,000 tax refund and above, and will correspondingly watch as your smile extends from ear to ear . The taxpayer is getting an amalgamation of, on occasion, a maxed out EIC, the Child Tax Credit and all of the money back they had withheld during the year from their checks..
Taxpayers received and average of $2,7000 back in their refund checks for 2011. And these refunds are often the result of deductions and credits being leveraged gross income before it is taxed, which is allowing them to shrink their money exposed to taxes by great amounts. Understanding deductions and credits can help you as a tax preparer, in that it can help your client get more money back. And getting your client an obese rembolso will increase the odds of them solidifying into a returning client, hopefully forever.