US Tax Deductions V Tax Credits

simon

Simon Misiewicz

4th August 2021

The frequently asked questions about Tax Deductions V Tax Credits

As tax accountants, we are regularly asked Tax Deductions V Tax Credits. We will look to answer the below questions in this Article.

“Are you paying too much tax?”

“What are the basics of Tax Deductions & Tax Credits?

“Is a Tax Deduction better than a Tax Credit?”

“What are the two types of Tax Deduction strategies?”

“How do I claim for Tax Deductions & Tax Credits?”

“What are the benefits of Tax Deductions?”

“What are the benefits of Tax Credits?”

“Is there a maximum that I can claim?”

“Which forms are needed to claim Tax Deductions & Tax Credits?”

“How does this affect our UK readers?”

Are you paying too much tax?

As US/UK ex-pat tax experts, we know that many of our clients come to us looking for ways in which to protect more of their investments as well as utilising strategies for mitigating tax.

There are many reasons why British people living in the United States pay far more tax than they need to.

This is because:

-They do not know what they do not know.

-They have not spoken to a tax specialist that knows all the UK and US tax laws.

-Their accountants in the UK are not knowledgeable when it comes to the US tax laws under the IRS.

-Their CPAs are not knowledgeable when it comes to the UK tax laws under HMRC.

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What are the basics of Tax Deductions & Tax Credits?

As UK/US tax specialists, we appreciate that it can be time-consuming and difficult to understand the basics of Tax Deductions and Tax Credits.

There are different reasons to apply for Tax Deductions compared to Tax Credits, and it is important to get the right tax advice before proceeding with either tax-reducing strategy.

A tax Deduction can only lower your taxable income and the tax rate that is used to calculate your tax.

This can result in a larger refund of your withholding.

A Tax Deduction reduced the amount of income you pay taxes on, so you pay less in taxes.

You subtract Tax Deductions from your income before calculating how much tax you owe. How much a deduction saves you depends on your actual tax bracket.

To calculate how much a deduction could reduce your tax bill, multiply the amount of the deduction by your tax rate.

For example, if a deduction is worth $5,000 and you are in the 10% tax bracket the deduction would reduce your taxes by $500.

If you pay a higher tax rate you can gain more benefit from a Tax Deduction.

If you take a $5,000 deduction but are in the 35% tax bracket, that would equate to a £1,750 tax saving.

Tax Deductions lower a person’s tax liability by reducing their taxable income.

Because a deduction lowers your taxable income it lowers the amount of tax you owe by decreasing your taxable income not by directly lowering your tax.

Tax Credits are considered by some to be better than Tax Deductions because they directly reduce the amount of tax owed.

The effect of a Tax Deduction on your tax liability depends on your tax rate.

A Tax Credit reduces your tax giving a larger refund of your withholding. Certain Tax Credits can give a refund even if you have no withholding.

A Tax Credit is a dollar-for-dollar reduction in the amount of income tax you owe.

If you qualify for a $1,000 Tax Credit and owe $5,000 in taxes, that credit will reduce your tax bill to £4,000.

A Tax Credit can be non-refundable or refundable.

The IRS has also provided clear guidance on Tax Deductions & Tax Credits that is worth reviewing.

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Is a Tax Deduction better than a Tax Credit? 

The main difference between Tax Deductions V Tax Credits is that deductions chip away at the income you pay taxes on which then reduces your taxes, while credits directly reduce the amount of taxes owed.

Some credits may even increase your refund or provide you with a refund despite not owing any tax.

 

What are the two types of Tax Deduction strategies? 

The two main types of Tax Deduction strategies are Standard Deduction and Itemizing.

Standard Deduction is a one-size-fits-all reduction in the amount of your income that is subject to tax.

You don’t have to do anything to qualify for it or provide any specific documentation to the IRS.

You can claim Standard Deduction by completing Form 1040. The amount varies on your filing status.

Read our article to find out everything you need to know about being a US Tax Filer and speak to us today.

Itemizing allows you to take advantage of tax deductions such as home mortgage interest, medical expenses and charitable donations.

If your itemized deductions exceed the value of the Standard Deduction you itemize so you pay less tax.

To do this, complete Form 1040 and Schedule A.

You can do one or the other, but not Standard Deduction and Itemizing.

It is also important to ensure that you meet the IRS criteria to qualify for both Tax Deductions and Tax Credits.

How do I claim for Tax Deductions & Tax Credits?

Add up all the itemized deductions you wish to claim for then compare whether taking the Standard Deduction or Itemizing route provides the largest reduction.

After applying all deductions, the figure left is your taxable income.

From this, you can apply any credits you are eligible for.

This is the simplest method to processing your tax bill to ensure that you take full advantage of all the Tax Deductions and Tax Credits you are entitled to.

What are the benefits of Tax Deductions? 

Tax Deductions are designed to offset the amount of income you’ll pay tax on by writing off expenses like tuition and healthcare, contributions to retirement and any self-employed or capital gains losses you incur.

Claiming a Tax Deduction ensures that you don’t pay tax on certain income you’ve already spent, invested or lost.

Common Tax Deductions include:

Many US taxpayers claim a Standard Deduction as outlined above as it can be simpler than itemizing all of their deductions individually. How much you can deduct using this method depends on your tax filing status and age.

If you pay interest on a qualified student loan, you may be eligible to deduct up to $2,500 on student loan interest.

Qualified medical and dental costs are tax-deductible as long as they exceed a set percentage of gross income.

You may be allowed to deduct state, local and foreign income taxes.

If you pay taxes for property that may be deductible.

If you pay mortgage insurance premiums or interest on a mortgage, they may also be tax-deductible.

Contributions to a traditional 401 (k) or an IRA are often eligible for deductions.

If you have a high-deductible health plan and contribute to an HSA in conjunction with that plan, your HSA contributions are usually tax-deductible.

What are the benefits of Tax Credits?

In addition to reducing the amount you pay in tax or increasing a refund amount, some Tax Credits can be claimed even if you have no tax liability.

Common Tax Credits include:

Earned Income Tax Credit (EITC) – this is a refundable Tax Credit for those who are working and earn a low to moderate income. Be aware that claiming this credit could delay ant tax refund you are owed because federal law requires the IRS to hold the refunds of anyone who claims this credit until mid-February.

Lifetime learning credit – depending on your gross income, you may be able to get a credit of up to $2,000 for qualified tuition and education-related expenses for yourself, a spouse or dependant.

Saver’s tax credit – this credit helps individuals who meet adjusted gross income requirements to save for retirement.

Residential energy-efficient property credit – as a homeowner, if you are investing in making your home more energy-efficient, you may be able to deduct those investments.

Is there a maximum that I can claim?

Between the tax years 2018-2025 there is no limit on Itemized deductions.

Individual limitations are in place on certain Tax Deductions such as medical and dental expenses.

When claiming an EITC you are capped at certain maximums.

For credits like the foreign tax credit, the amount you are eligible for is a fraction comprising the tax paid to non-us tax entities divided by the total amount owed to the IRS and entities abroad.

If you are married but filing separate tax returns and want to itemize deductions, your spouse will also have to itemize. Likewise if one of you choose the Standard Deduction route, the other must also do this.

When it comes to Itemizing, you will need well-documented records to claim certain deductions.

This is generally more work than simply claiming the Standard Deduction.

For example, if you’re claiming business use of your car, you often need proof in the form of a mileage log highlighting business and personal use.

To get the most from Tax Deductions & Tax Credits, speak to an experienced tax adviser today.

Which IRS forms are needed to claim Tax Deductions & Tax Credits? 

For Tax Deductions, you can claim the Standard Deduction on Form 1040.

But if you are looking to Itemize your Tax Deductions, you will need to fill out Form 1040 and Schedule A.

For claiming Tax Credits, you must fill out Form 1040.

You may be interested in our main Article on UK Tax status if you are looking to move to the UK or from the UK. You may also be interested to know how more about our property tax services if you are looking to invest in the UK buy to let properties.

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