Here’s a typical year in the life of clients I work with:
- They bought their first house and installed new windows
- They bought a new computer for their freelance gig
- They had a baby that started daycare at three months old
- They’ve got a few years left of student loan payments
- They got LASIK
- They donated money to charity
As you can see, things get expensive in your 20s and 30s! But tax credits and deductions can ease the burden (and all of those things listed above are potentially eligible). So, just by living your life, you’ll be able to pinpoint places to save money at tax time!
Here’s a breakdown of how deductions and credits work.
What Are Tax Deductions?
When people talk about a “tax write-off,” they’re talking about deductions. Tax deductions are expenses you pay for that can be subtracted from your taxable income. If you earned $75,000 last year but were able to claim $10,000 in deductions, for example, you’re taxed on $65,000 instead.
Standard Deduction vs. Itemized Deduction
You can choose between taking the standard deduction or itemizing your deductions (whichever is the higher amount). Most people choose the standard deduction, which was $6,300 (single), $12,600 (married filing jointly), or $9,300 (head of household) for 2016.
Taking the standard deduction is the better bet if you don’t have many expenses that would qualify for deductions. You also save a lot of time! Gathering proof of deductible expenses can take a lot of work, and isn’t worth it if those expenses don’t add up to more than your standard deduction.
However, if you have enough itemized deductions to exceed the standard deduction amount, it’s worth it to itemize.
For example, if 2016 was the year you bought and/or sold a home, or paid some steep out-of-pocket medical expenses, you might choose to itemize your deductions.
There are a lot of deductible expenses! Remember you can only claim these if you opt to itemize instead of taking the standard deduction, with few exceptions. Here are some of the more common ones:
- Medical and Dental Expenses: You can deduct medical expenses as long as they exceed 10% of your adjusted gross income (AGI). This includes things like travel to and from medical treatments, LASIK eye surgery, and uninsurable expenses like glasses and contacts.
- Educational Expenses: This includes deductions for tuition and fees (there are tax credits you can take instead), student loan interest, and work-related education.
- Home Ownership Expenses: You can claim deductions for property taxes, mortgage interest, gains on the sale of your home, points you buy to obtain a more favorable mortgage, and more. If you relocate by 50 miles or more for a new job, you can deduct things like the cost of movers and a storage unit, and even the cost of driving or flying you and your family to your new home.
- Charitable Donations and Volunteer Work: Donations of up to 50% of your AGI are deductible (though there are some limitations on what the IRS considers a charitable organization, and that can affect your deduction). If you donate items like clothing or furniture, you can deduct 50% of the resale value the organization can get for the items. If you volunteer for a charitable organization, you can deduct expenses like transportation or travel to events, out-of-pocket expenses for items you buy for the charity, and even the cost of a uniform if you’re required to wear it while volunteering.
- State and Local Taxes: You can choose to deduct either state and local income taxes or state and local sales taxes (but not both).
- Traditional IRA Contributions: Deductions are available if you contribute to a traditional (non-Roth) IRA, but there are limits based your income and on whether you (or your spouse) are eligible to contribute to an employer-sponsored retirement account like a 401(k).
- Health Savings Accounts (HSAs): You can claim a deduction for your HSA contributions even if you don’t itemize.
- Running a Business: If you’re self-employed or work as a freelancer, you can deduct business expenses like buying equipment, attending classes or conferences, and more.
What Are Tax Credits?
Tax credits are dollar-for-dollar reductions of the income tax you owe the government. So if you owe $5,000 and get a $2,000 tax credit, you’ll owe $3,000.
Some tax credits are refundable, meaning you’ll still get the full value of the credit even if it exceeds what you owe. So if you owe $1,500 and get a $2,000 refundable tax credit, you’ll get a $500 refund.
Other tax credits are nonrefundable, meaning if the credit exceeds the taxes you owe, you can reduce your tax bill to zero, but not get the remainder of the credit in the form of a refund.
What Kinds of Tax Credits Exist?
There are many tax credits available, but you probably only qualify for a few. Tax preparation software like TurboTax can help identify which credits you’re eligible for. Your best bet, however, is working with an accountant who will discuss your personal situation and make the appropriate suggestions.
Here are some common credits taxpayers can qualify for:
- Saver’s Credit: If you earned less than $30,750 (single), $61,500 (married filing jointly), or $46,125 (head of household) in 2016, you may be able to take a tax credit for your contributions to an IRA or employer-sponsored retirement account.
- Educational Credits: There are two tax credits available and you might qualify for one of them if you had education expenses in 2016. The American Opportunity Credit lets you claim a credit of up to $2,500 for qualified education expenses for up to four years. The Lifetime Learning Credit gives you a $2,000 credit with no limit on the number of years you can claim it. There are income limits and other specifications.
- Home Purchase and Improvement Credits: First-time home buyers might qualify for the Mortgage Credit Certificate toward a portion of their mortgage interest. The credit amount varies by state and there are income limits. And if you made improvements to your home to increase its energy efficiency (like installing energy-efficient windows, roofing, or an HVAC system), you can get some of the expense back in the form of a tax credit.
- Credits for Parents: The Child Tax Credit provides up to $1,000 for each child under 17, with that amount lowering if you earned more than $75,000 (single) or $110,000 (married filing jointly) in 2016. If you earned less than $47,955 (single) or $53,505 (married filing jointly) and have three or more children, you qualify for the Earned Income Tax Credit. The Child and Dependent Care Credit will cover up to 35 percent of child-care expenses, or up to $3,000 for a child under 13 (your employer might deduct up to $5,000 for child care expenses, which is more beneficial if you have one child because you can’t use both credits).
Don’t Be Afraid to Ask for Help!
In addition to other ways to save on your taxes, tax credits and deductions exist to help offset the cost of different expenses you might incur throughout your life. While you don’t want to fudge your tax return to get more money back (don’t mess with the IRS!), you should take advantage of everything that’s available to help you.
Doing your own taxes is possible, but the more complicated your situation is, the more I recommend working with a CPA or tax accountant (I don’t do my own taxes!).
They cost a few hundred dollars, but they’ll save you hours of time and be able to guide you through the deductions and credits you’ll be eligible for. How much is your time worth? If you’re making six-figures, a solid CPA is a must.
They can do some complex tax projections for you to find out how your taxes will be affected by things like maxing out a pre-tax retirement account or rolling over an old 401(k) into an IRA. During a stressful time like tax season, a good accountant will be your best friend!