Tax Credits vs. Tax Deductions

Tax credits and deductions both lower your total tax liability. However, there is a clear difference between the two. Generally speaking, a credit is more advantageous.

A tax credit reduces the actual taxes owed. In other words, the amount of the credit is deducted from the actual tax liability. So, if you owe $5,000 in tax based on your taxable income, but you are also eligible for a $1000 credit, you will only owe $4,000 in taxes for the year.

A tax deduction decreases your adjusted gross income, which in tax jargon is more commonly known as your AGI. Your AGI is used to determine your taxable income, which in turn determines your tax liability depending on your filing status. As you can see, a tax deduction is a little more far removed from the actual calculation of tax, making it less predictable than a credit. Not only that, a deduction is not a dollar for dollar reduction of tax, so the deduction does not yield as high of a tax savings as a credit.

Using the example above, if you owe $5,000 in tax as a person filing single, your taxable income is around $34,600. If we add an additional $1,000 deduction as we did with the credit in the previous example, the taxable income is now $33,600. The new tax owed on this amount for a person filing single is $4,750. So, a $1,000 deduction for a person filing single lowers the tax liability by $250. Obviously, a $1,000 credit for this person yields $750 more in tax savings than a $1,000 deduction.

Some of the tax credits available are as follows: Hope and Lifetime Learning education credits (Form 8863), Child and Dependent Care credit (Form 2441), Elderly and Disabled credit (Schedule R), Retirement Savings Contribution credit (Form 888), the Child Tax Credit (Form 8901), and the Adoption credit (Form 8839). There are also many others for which you may be eligible.

Some of the tax deductions available are as follows: Health Savings Account, Tuition and Fees, Moving expenses, Alimony paid, IRA contributions, Penalty on early withdrawal of savings, Educator expenses, various self-employed deductions, and many others.

TaxBrain asks you as series of questions, and then based on the answers to those questions, determines which credits or deductions are available for your situation, making the preparation of your return as painless as possible.

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The Standard Deduction vs. Itemized Deductions

Generally speaking, a deduction is an amount that lowers your taxable income. Congress has decided that certain items are necessities of life or encourage positive social behavior, and therefore, people should not have to pay taxes on income earned to pay for these items. Two examples include home ownership and medical costs.

Some of these deductions have been grouped together and are available only by using one of two methods. The “standard deduction” is an amount already predetermined which can be used as a total for these deductions even if you did not actually pay this much for these expenses. Alternatively, you can “itemize” your deductions which means you deduct the actual amounts paid for these specific items. This is accomplished via Schedule A.

This group of deductions, also called Schedule A deductions, include medical and dental costs, state and local taxes, mortgage interest, charitable contributions, casualty and theft losses, job expenses, and a few other miscellaneous items.

This sounds pretty easy except that certain AGI limits and expense thresholds apply, making the calculation of the deduction and the determination of which method yields the lowest taxable income somewhat complicated. TaxBrain allows you to enter all of your Schedule A expenses, and then calculates your allowable deduction and decides whether to apply the standard deduction or your itemized deduction to yield you the highest tax savings.

The standard deduction for 2008 is as follows:

• $10,900 if married filing jointly or if a qualified widow or widower,
• $5,450 if filing single or married filing separately, and
• $8,000 if filing head of household.

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Refundable vs. Nonrefundable Tax Credits

These two types of credits are calculated exactly the same way by subtracting the amount of the credit from your tax liability. However, the difference lies in what happens if you do not have any tax liability or if the credit reduces your tax liability below zero. If the credit is nonrefundable and this occurs, then you owe no tax. If the credit is refundable and this occurs, you will receive a refund of the credit even though you have no tax liability to absorb it.

In understanding this concept, it is also important to understand the difference between tax liability, tax refund, and tax owed. Your tax liability is the amount of tax you must pay or have already paid for the current tax year. If you have already paid (either through withholding or estimated tax payments) more than your tax liability, you will receive a tax refund. This does not mean you don’t have any tax liability-it only means that you have already paid more than your share of tax liability. If you have not paid enough when you file your tax return, you will owe tax. This means that you had some tax liability, and you did not pay all of it during the tax year.

The availability of a nonrefundable credit is affected only by your tax liability. For example, if you had $5,000 of tax liability but paid $8,000 already, you will be due a $3,000 refund. If you additionally have a $4,000 nonrefundable credit due to you, because your tax liability is more than this, you will now receive $7,000 as a refund. If on the other hand, you have $0 of tax liability but paid $3,000, you will still be due a $3,000 refund. However, if you additionally have a $4,000 nonrefundable credit due to you, you will not receive any of the credit because you had no tax liability. You will only receive your $3,000 refund. In either of these cases, had the credit been refundable, you would receive the full $4,000 of the credit because your tax liability would not matter.

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Deductible Mortgage Insurance Premiums

Mortgage insurance premiums paid during the current tax year for the current tax year are deductible if qualified. To be qualified, the mortgage insurance must be provided by the Department of Veterans Affairs, the Federal Housing Administration, the Rural Housing Service, or a private mortgage insurer as defined in section 2 of the Homeowners Protection Act of 1998 as in effect on December 20, 2006. Additionally, the premiums must be made in connection with a debt secured by your first or second home, and the insurance contract must have been issued after December 31, 2006. “Funding fees” and “guarantee fees” also may qualify.

Check your loan documents or call your lender to find out whether your mortgage insurance premiums qualify for this deduction.

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Clothing Deductions

The rules for taking a deduction for the purchase and upkeep of work clothes are very strict. Specifically, the clothes must be worn as a condition of employment, and the clothes cannot be appropriate for everyday wear. For example, a painter who wears bib overalls and a white cap cannot deduct these expenses because these clothes would normally be worn out in public. This also includes very expensive brand name clothes required for certain occupations that are appropriate in public. On the other hand, a postal worker would not normally wear a U.S. post office uniform out in public, so that type of uniform is deductible. Also, expenses for protective clothing such as safety glasses, hard hats, and work gloves are allowed if they are necessary for your job. Learn more at http://www.irs.gov/publications/p529/ar02.html#d0e1288

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Additional Standard Deduction for Taxpayers with Real Property Taxes

A new law effective for 2008 allows an increase in the standard deduction if you pay any state or local real estate taxes. At this point in time, this increased deduction is only available for 2008. The increase in the standard deduction will be limited to the lesser of either the following:

1. $500 ($1,000 for married filing jointly), or
2. The amount of property taxes actually paid during the year.

This will be a great benefit to taxpayers who own their home but do not pay enough expenses to itemize deductions.

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IRA Contributions

IRA contributions to a traditional IRA are deductible within certain limits from the taxpayer’s taxable income regardless of whether the taxpayer itemizes deductions. The first limit is how much is deductible. For 2008, up to the lesser of $5,000 or the taxable compensation for the year is the most that can be contributed to an IRA and deducted from taxable income for most taxpayers. If the taxpayer was 50 or older at any time during the tax year, the first amount is increased to $6,000.

The second limit is based on your modified adjusted gross income (MAGI). The deduction is phased out between certain income levels and eliminated above those levels. For 2008, the limits are as follows:

1. More than $85,000 but less than $105,000 for married couples filing a joint return or qualifying widows or widowers,
2. More than $53,000 but less than $63,000 for single individuals, including those filing Head of Household, and
3. Less than $10,000 for a married individual filing a separate return.

TaxBrain automatically calculates the proper deduction based on how much you contributed to your IRA during the year. Also, you can include contributions to your IRA made through April 15th of the following year.

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Medical Expenses that Qualify as Tax Deductions

A medical expense is a Schedule A deduction and must meet certain requirements to be deductible. First of all, it must be related to the diagnosis, cure, mitigation, treatment or prevention of disease.

Examples of deductible medical expenses includes all of the following: professional services from physicians, surgeons, and pediatricians; dental services such as cleaning, x-rays, and the cost of purchasing artificial teeth; medical equipment and supplies such as eyeglasses, walkers, wheelchairs, back supports, braces, and abdominal support; medical treatment such as acupuncture, insulin treatments, x-ray treatments, and blood transfusion; prescription medicine and drug; and laboratory exams and tests such as blood tests, spinal fluid tests and stool examinations.

Also included are other indirect medical expenses such as the following: hospital services such as hospital bills, vaccines, and x-ray technician bills; medical care premiums; qualifying long term care costs; childbirth classes; “seeing eye“ dogs and maintenance; smoking cessation classes; and travel to obtain medical care.

What are not included as deductible medical expenses are those costs related to benefiting your general health. Included in this category are cosmetic surgery that does not have a medical purpose, over-the-counter drugs, vitamins, supplements, health foods, weight-loss clinics, massages, other spa services, and travel without the sole purpose being to obtain qualified medical care.

The second requirement is that the medical expenses be for you, your spouse, or your dependent. To deduct your spouse’s medical expenses, you must have been married either when the services were received or when they were paid. To deduct your dependent’s medical expenses, the person must have been your dependent either when the services were received or when they were paid. You cannot deduct medical expenses you pay for any other individual unless it is as a charitable contribution and paid to a qualified charitable fund.

The third requirement is that the total amount of medical expenses must be more than 7.5 percent of the taxpayer’s adjusted gross income (AGI). Also, only unreimbursed expenses are deductible. Self-employed individuals are the only taxpayer’s not subject to this 7.5 percent rule.

If you have had complicated medical expenses or catastrophic health problems during the past year, you may wish to seek professional tax assistance to further minimize your tax liability.

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Moving Expense that Qualify as Tax Deductions

Taxpayers may deduct certain moving expenses when relocating to a new job location regardless of whether they itemize deductions. To be eligible for the deduction, there are three tests that must be met to determine whether the taxpayer moved far enough away, for a long enough period of time, in a move closely related to the start of the new job.

The Distance Test, or '50 mile test', states that your new job location must be at least 50 miles farther from your former home than the former job location was from your former home. If there was no former job location, then the new job location must be at least 50 miles from your former home. To eliminate any confusion, this test does not consider the location of the new home or the distance from the new home to any point.

The Time Test, or ‘39 week test’ states that you must work at least 39 weeks during the 12-month period immediately following arrival in the new area. The 39 weeks do not have to be consecutive or with the same employer, but they do have to consist of full-time work within the same general commuting area, and cannot include any self-employed work. If you lose your job through no fault of your own, such as a plant closing or downsizing, the 39-week requirement can be waived. If you are self-employed, the rules are slightly different. In addition to the rules for an employee, you must also work at least 78 weeks during the 24 months after arriving in the new area. However, unlike the rules for employees, all full-time work counts, including work as a self-employed person and as an employee.

The Closely Related Test requires that the move be closely related both in time and in place to the start of work. Generally, expenses incurred within one year either before or after the taxpayer begins the new job are considered closely related in time to the move. To be related in place, the distance from the new home to the new job location cannot be more than the distance from the former home to the new job location. However, this is a flexible rule if you can show that you are required to live at the new home as a condition of employment or if the commuting time and costs are less.

You cannot include moving expenses that have been reimbursed by your employer or anybody else.

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Standard Mileage Rate

The standard mileage rate is a fixed amount the tax laws allow for a deduction based on the number of miles driven for a specific purpose. If you have deductible miles, you can decide whether to use the standard mileage allowance or compute the actual costs expended. Using the standard mileage allowance eliminates the need to keep complete records of fuel, maintenance, and insurance costs along with depreciation. Instead, you only have to keep records of when, where, and why you drove somewhere, along with how many miles were involved. This is especially helpful if you use the same vehicle for both deductible and non-deductible purposes or if you use more than one vehicle for a deductible purpose. There are a few standard mileage deductions available to you depending on why you were traveling.

If you decide to use actual expenses, all of the expenses, including depreciation, related to the business use of the vehicle are deductible. The only actual expenses allowed for charitable contribution and medical expense mileage are the costs of gas and oil directly related to the mileage. Regardless of which method you use to deduct mileage, the costs of parking fees and tolls can be included in addition to both actual expenses or the standard mileage deduction.

If you used your automobile for business purposes, the standard mileage rate in 2008 is 50.5 cents per mile for travel between January 1, 2008 and June 30, 2008 and 58.5 cents per mile for travel between July 1, 2008 and December 31, 2008.

If you used your automobile for charitable purposes, the standard mileage rate in 2008 is 14 cents per mile. If the charitable purpose was to help provide relief in a Midwestern disaster area, the standard mileage rate in 2008 is 36 cents per mile for travel between January 1, 2008 and June 30, 2008 and 41 cents per mile for travel between July 1, 2008 and December 31, 2008.

If you used your automobile for medical purposes, the standard mileage rate in 2008 is 19 cents per mile for travel between January 1, 2008 and June 30, 2008 and 27 cents per mile for travel between July 1, 2008 and December 31, 2008.

Taxpayers must keep accurate written records for tax purposes regardless of the method used to deduct mileage. Keep a mileage log with beginning and ending odometer readings and record the trip’s purpose. If you are taking a deduction for actual expenses, keep a record of all of your receipts related to the operation of the vehicle.

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Mortgage Interest Credit

Taxpayers may obtain a “mortgage credit certificate” to finance the purchase of a principal residence or to borrow funds for certain home improvements. This credit is found under special state and local programs. Generally, a qualifying principal residence may not cost more than 90% of the average area purchase price, higher in certain targeted areas. A tax credit for interest paid may be claimed using Form 8396 to compute the credit.

The mortgage interest credit is nonrefundable. For example, the credit for 2006 cannot exceed your 2006 regular tax, plus any alternative minimum tax reduced by other personal credits such as child and dependent care credits, education credits, and child tax credit. The unused credit difference between the allowable credit exceeding the liability limitation can be carried forward up to three years.

If you itemize deductions, you must reduce your home mortgage interest deduction by the current year mortgage interest credit (Form 8396, line 3). The reduction of the mortgage interest deduction is applicable even when carrying forward the credit.

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What is the Earned Income Credit?

More commonly known as the EIC, this is a refundable credit available to you if you have a certain range of earned income with that range varying depending on how many qualifying children you have. For 2008, your adjusted gross income must be less than the following:

• $38,646 ($41,646 for married filing jointly) with more than one qualifying child,
• $33,995 ($36,995 for married filing jointly) with one qualifying child, or
• $12,880 ($15,880 for married filing jointly) with no qualifying child.

Other requirements apply, and penalties will incur if you improperly claim this credit.

TaxBrain automatically determines whether you qualify for this credit, so there is no need to worry about completing the IRS worksheets and risking the possibility of erroneously claiming EIC. Also, because this is a refundable credit, you may be eligible even if you do not have any tax liability or are not otherwise receiving a refund.

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The Child Tax Credit and Additional Child Tax Credit

The Child Tax Credit is a nonrefundable credit that is available in addition to the Earned Income Credit and Child and Dependent Care expenses, up to $1000 per qualifying child. The credit is reduced and eventually eliminated if your modified adjusted gross income is $75,000 if filing single, head of household, or as a qualifying widow or widower, $110,000 if married filing jointly, and $55,000 if married filing separately.

The Additional Child Tax Credit is refundable and may be available if you do not qualify for the full Child Tax Credit. This credit is based on your earned income.

TaxBrain automatically calculates both of these credits and includes the required form to your return.

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Education Credits

Hope Credit

• Up to $1800 credit per eligible student ($3600 if student in Midwestern disaster area)
• Available ONLY until the first 2 years of postsecondary education are completed
• Available ONLY for 2 years per eligible student
• Student must be pursuing an undergraduate degree or other recognized educational credential
• Student must be enrolled at least half time for at least one academic period
• No felony drug conviction on student's record

Lifetime Learning Credit

• Up to $2000 credit per return ($4000 if student in Midwestern disaster area)
• Available for all years of postsecondary education and for courses to acquire or improve job skills
• Available for an unlimited number of years
• Student does not need to be pursuing a degree or other recognized educational credential
• Student can be enrolled in as few as one course
• Felony drug conviction rule does not apply

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The First-Time Homebuyer Credit

Created in the Housing Assistance Tax Act of 2008, a first-time home buyer credit is being provided as a refundable tax credit that is equivalent to an interest-free loan for home purchases made between April 9, 2008 and December 31, 2008. This is a somewhat new type of hybrid credit because it is only temporary and must be repaid in equal installments over a period of 15 years beginning two years after the credit is taken. The first installment will be due as an additional tax on your 2010 tax return. It is really an interest-free loan from the government.

Congress has also just recently passed an extension of this credit for homes purchased in 2009. This credit must be repaid only if the home ceases to be your main home or if you sell the home within the 36-month period beginning on the purchase date. Otherwise, this is just like an ordinary refundable credit.

The following guidelines explain the requirements and eligibility for this credit:

1. A taxpayer is considered a first-time home buyer if there was no ownership interest in a principal residence during the three-year period before the new home was purchased.
2. For homes purchased in 2008, the credit can be up to the lesser of 10 percent of the purchase price of the home or $7,500 ($3,750 for married filing separately). The limit is increased to $8,000 ($4,000 for married filing separately) for homes purchased in 2009.
3. The credit phases out for taxpayers who have an adjusted gross income (AGI) between $75,000 and $95,000 ($150,000 and $170,000 if married filing joint). The credit is eliminated for AGI’s above those amounts.
4. The provision applies to homes purchased on or after April 9, 2008 and before December 1, 2009;
5. A first-time homebuyer who purchases a principal residence between January 1, 2009, and December 1, 2009, has the option of filing an amended 2008 return to claim the credit even though the purchase did not occur until 2009.
6. The IRS will disallow the credit if the taxpayer disposes of the residence before the close of the tax year for which the credit would be allowed.
7. Qualified purchases do not include purchases from related persons.

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The Residential Energy Efficient Property Credit

This nonrefundable credit allows you to be reimbursed for up to 30% of your costs expended for purchasing and installing property that is any of the following:

• Qualified solar electric property
• Qualified solar water heating property,
• Small wind energy property,
• Geothermal heat pump property, or
• Qualified fuel cell property.

Check with the vendor who sold you the equipment or the person who installed the equipment to find out whether your are eligible for this credit.

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Saver's Credit or Retirement Savings Contribution Credit

This nonrefundable credit is intended to reward low-and-moderate income taxpayers who save for retirement. To be eligible in 2008, your adjusted gross income must be less than $26,000 if filing single, $39,750 if filing head of household, and $53,000 if married filing jointly.

The credit can be as high as $1,000, and the actual credit allowed depends upon your income, filing status and just how much you put into retirement plans. Basically, the lower your income, the bigger your credit. And since the tax break is a credit instead of a deduction, it's a better deal.

TaxBrain automatically applies the credit based on income, 401K, IRA contributions and other qualifying factors. Just preview your tax return and look for Form 8880. It's that simple!

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