Taxes are notoriously one of the most complicated things to understand. For the everyday citizen, taxes are a once-a-year headache that we are happy to pay someone else to do for us. Some like to do the taxes themselves or let software make a pass, but very few people actually understand the process, the lingo, and to some degree the point.
Like investing, there’s little point in trying to understand the system when there are professionals that do it 40+ hours a week. You aren’t going to beat them. But you don’t want to just blindly hand over your finances or taxes to a professional without understanding some of the basics either.
The gateway to understanding taxes are the various methods in which you can reduce the amount of money you owe the government. Deductions, credits, refunds, standard deductions, itemized deductions… it’s all kind of confusing. So confusing that I’ve never bothered to try and understand it, just allowing my accountant to handle everything. This year though I wanted to try and guess my refund just as a check to see if I really know what I’m doing. But I could barely get started because of all the confusing methods out there to reduce the tax bill.
So for your sake and mine I want to clarify these things once and for all:
Credits: These are probably the best things you can get to lower your tax bill or increase your refund. Credits directly reduce the amount you owe. So say you’ve gone through the process of filling out your tax forms and you owe the government $10,001 in taxes, and you paid $7500 in taxes last year. A $2500 credit would bring your total tax bill down to $7501, and you would have to right a check for $1 instead of $2501. Examples of tax credits are for a portion of college expenses, child care, and that first time home-buyer credit that expired a couple of years ago.
Deductions: Deductions are the ones you hear about the most. Whereas the credits reduce the amount you owe directly, adjustments reduce your taxable income. Assume you made $50k last year, a deduction of $1000 means you’ll only be taxed on $49k of income. They reduce the amount you owe less than credits do (dollar for dollar), but of course shouldn’t be ignored. Examples of these deductions are donations to charities, mortgage interest, and local taxes.
Before we go to the last category, the most confusing aspect of deductions needs to be addressed. In order to get these tax deductions, you must choose to itemize the expenses. So you can’t just make up a list, you have to list everything you want to deduct, and you should be prepared to have supporting documentation as this is likely many audits come from sketchy deductions. You can choose to not itemize your deductions and just take the standard deduction. This is a flat rate and you don’t have to provide any documentation. Generally, if the total value of your itemized deductions is greater than the standard deduction would be, you probably want to itemize.
Adjustments (AKA: Above the line deductions): Now that we cleared up the itemizing, there are deductions you can take even if you don’t itemize. This is an area of the tax code that even on its most basic level is unnecessarily complicated and makes things more difficult for normal people to do their own taxes. In some circles, these are called “adjustments” or “above the line deductions”. The reference to above the line is a specific line on the tax forms for adjusted gross income. So even if you don’t itemize, these are deductions you can still take. Like the deductions above, they reduce the amount of income you are taxed on. They are not like credits. Some examples are the interest on student loans, alimony payments, and IRA contributions (not the Roth).
Even this world is not as simple as I’ve made it. Adjustments reduce your adjusted gross income (AGI) which is what drives what you are eligible for with credits and deductions as many are phased out as income goes up. From best to least best the ranking goes: Credits, adjustments, then deductions.
But of course we aren’t done. We didn’t talk about tax exemptions at all. They are a kind of deduction that occurs below the line, but don’t have to be itemized. Many times you elect exemptions for a spouse or child when you fill out tax forms at work.
Is there still more stuff out there? I’m sure. Did I get something wrong? Possibly (as always call it out in the comments). But this really gives you all you need to know about taxes, and by that I mean it should convince you to not try and do it yourself. This post is not about advice. I prefer a human being professional, but many like using the software stuff. You’re on your own there.
Image: David Reber’s Hammer Photography
 By The Weakonomist |
The Weakonomist is the founder of Weakonomics. Clicking the picture of the puppy will tell you more about him. If you like what you're reading consider subscribing to the blog, following him on Twitter, and checking out the related posts below. Please consider a donation if you really enjoy Weakonomics. Also keep in mind that nothing I say can be construed as financial advice. |
