- Learn about non-business deductions.
- Find information about tax brackets.
- Learn about above-the-line deductions.
- Discover information about itemized deductions.
- Learn about some valuable business deductions.
- Get information about the benefits of tax credits.
Individuals are always looking for tax deductions that can reduce their tax liability. But what actual tax benefit can you derive from tax deductions? There is no straightforward answer because some deductions are “above the line”, others must be itemized, some must exceed a threshold amount before being deductible, and certain ones are not deductible for alternative minimum tax purposes, while business deductions can offset both income and self-employment tax. In other words, there are many factors to consider. The tax benefits also differ for everyone, depending on their particular situation and tax bracket.
What You Need to Know About Tax Deductions
Tax brackets
For most non-business deductions, the savings are based on your tax bracket. For example, if you are in the 12% tax bracket, a $1,000 deduction would save you $120 in taxes. On the other hand, if you are in the 32% tax bracket, the $1,000 deduction will save you $320 in taxes. Even so, if your taxable income is within the amount of the deduction to transition into the next-lower tax bracket, the benefit will be lower.
You also need to consider whether the deduction is allowed on your state return and what your state tax bracket is. This will determine the total tax savings. Currently, the maximum federal tax bracket is 37%. This means that the most benefit that can be derived from a $1,000 income tax deduction is $370.
Some individuals justify making discretionary purchases just because they are tax-deductible. Even in the highest Federal tax bracket, you are still paying $630 out of pocket ($1,000 − $370) for every $1,000 deduction. So, it does not make sense to incur a tax-deductible expense just for the tax deduction.
Above-the-line vs itemized deductions
Some deductions, such as IRA and self-employed retirement plan contributions, alimony, and student loan interest, are adjustments to income or what we call above-the-line deductions. These deductions, to the extent permitted by law, provide a dollar deduction for every dollar claimed. On the other hand, deductions that fall into the itemized category must exceed the standard deduction for your filing status before any benefit can be derived.
In addition, qualified medical expenses are deductible only to the extent they exceed 7.5% of your adjusted gross income (AGI), and most cash charitable deductions are limited to a maximum of 60% of your AGI. Under the tax reform effective in 2018, the deduction for state and local taxes currently caps out at $10,000 per year.
Tax deductions for the self-employed
The most beneficial deductions are business deductions that offset both income tax and, depending upon the circumstances, self-employment tax. For 2023, the self-employment tax rate equals 12.4% of the first annual inflation-adjusted $160,200 of net self-employment income plus 2.9% for the Medicare tax, with no cap. Contact your Fiducial representative for rates applicable to other years. Some high-income taxpayers may pay an additional 0.9% Medicare tax.
For self-employed businesses with less than $160,200 of net income, the self-employment tax rate is 15.3%. Thus, for small businesses with profits of less than $160,200, the benefit derived from deductions generally will include the taxpayer’s tax bracket plus 15.3%. For example, for a taxpayer in the 24% tax bracket, the benefit could be as much as 39.3% (24% + 15.3%) of the deduction. If the deduction were $2,000, the tax savings could be as much as $806 or more, when the taxpayer’s state income tax bracket is included.
Valuable Tax Credits
In addition to deductions, taxpayers also benefit from tax credits. Tax credits reduce the tax, not the taxable income, dollar for dollar. These credits come in different varieties. Some, referred to as non-refundable, will only reduce a taxpayer’s tax liability to zero while refundable credits will reduce the tax liability to zero and any balance is refunded. In addition, some unused non-refundable credits can carry to other years. The following are examples of 2023 tax credits:
- Earned Income Tax Credit (EITC) – This inflation-adjusted credit is for lower-income taxpayers based on their earned income and overall income for the year. The credit can be as much as $7,430 and is a refundable credit.
- Home Solar Credit – 30% of the cost of a home solar electric system put into service in 2023. The credit is non-refundable, but unused credit carries over to future years.
- Credit for Energy-Efficient Home Modifications – This credit is 30% of the cost of making qualifying energy-saving improvements to your existing home. The costs, and thus the credit, is limited by the type of home improvement, and the annual maximum credit is $1,200. However, this is a non-refundable credit and there is no carryover.
So when evaluating the tax benefit of a tax credit one must consider whether it is a refundable credit; if any unused amounts carry over to be used in other years; and whether there are any limits on the dollar amount of the credits.
Next steps
Planning an expenditure and expecting the tax deduction or tax credit to help cover the cost? Call before making the purchase to ensure that the tax benefit will be what you anticipate. Call Fiducial at 1-866-FIDUCIAL or make an appointment at one of our office locations to discuss your situation.
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