Both tax deductions and credits help reduce your members’ income tax liability but in different ways and for different reasons. And they may not understand the difference. Being able to educate your members about tax details like this puts you in the position of trusted financial resource.
Understanding how tax deductions and credits work, how they affect a member’s filing status and yearly expenses, and what receipts they should be keeping throughout the year will help them hold on to more of their money come tax season. And that means more money to save at your credit union.
Tax deductions lower someone’s taxable income based on their marginal tax bracket. Broken down into simple numbers and terms, that means if they’re in the 22 percent tax bracket, a $1,000 tax deduction saves them $220 they don’t have to pay in income tax (0.22 x $1,000 = $220). They can think of it as reducing the amount they are taxed on.
There are two main types of tax deductions: standard deductions and itemized deductions. A member can only use one of these deductions when filing. The good news is, they get to choose whichever type of deduction saves them the most money.
Standard deductions are set before the start of each year, and while the amount of each deduction usually changes, the categories do not. The categories of standard deductions and their 2019 tax year amounts are: single filing status, $12,200; married filing together and surviving spouse, $24,400; married but filing separately, $12,200; and head of household, $18,350.
Itemized deductions are used when their total exceeds the standard deduction of a taxpayer’s filing status. Qualified expenses include medical expenses, property taxes, charitable donations, mortgage interest, and others. Some itemized deductions are based on a “floor” amount, or minimum, so they can only deduct the amount if it exceeds the specified floor.
If a member decides to itemize their tax deductions, it’s important they keep detailed records of those expenses throughout the year to ensure they maximize their deduction and to ensure they don’t miscalculate and chose itemization over taking the standard deduction.
When considering whether to use standard or itemized deduction, members should know there is an income limit for those who itemize their deductions.
Where tax deductions reduce what taxpayers owe by decreasing the amount they are taxed on, tax credits are a dollar-for-dollar reduction of their income tax liability, the amount they owe in taxes. So, a $1,200 tax credit saves them $1,200 in taxes owed. Tax credits depend on several factors, including taxpayer income, age, filing status, and other qualifications.
There are fewer tax credits than tax deductions. They are available for things like adopting a child, child care expenses, buying a first home, home office expenses, and caring for elderly parents. There are also business tax credits to consider. It’s important to know that most tax credits are non-refundable and expire in the year they were used, so the additional amount is not paid back to them in their tax refund.
In the end, tax credits are worth more than a dollar-equivalent tax deduction; e.g., for that taxpayer in the 22 percent tax bracket, a $1,000 credit is $780 more in savings than a $1,000 deduction, which only saves them $220. Both tax credits and deductions can help members pay less in taxes and gives them more options for savings and investments with their hard-earned money.