How to Pay Less in Taxes (Part 1)
Money Girl explains tax credits and how they help you pay less tax and save more money.
Laura Adams, MBA
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How to Pay Less in Taxes (Part 1)
When you consider how you’d like to spend your hard-earned paycheck, paying taxes probably doesn’t come to mind. But did you know that they’re probably your largest expense, next to housing?
Since taxes take such a big bite out of your income, it’s smart to cut them every way possible. This is the first episode in a 2-part series about how to legally pay less taxes and save more money..
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How Many Taxes Do You Pay?
I’m sure you’ve heard the saying, “In this world nothing is certain except death and taxes.” Benjamin Franklin is credited for that famous phrase. I’ve often wondered what he’d think about all the dozens of taxes we have to pay these days.
There’s federal income tax, state tax, sales tax, gasoline tax, capital gains tax, estate tax, gift tax, food tax, alcohol tax, property tax, and business tax, just to name a few. Taxes are baked into just about every financial transaction, no matter if you’re earning or spending money.
Of course, you should never do anything illegal to avoid paying taxes. But there’s nothing wrong with making sure that you don’t overpay. Even the Internal Revenue Service (IRS) encourages taxpayers not to pay more in taxes than the law requires.
What’s the Difference Between a Tax Deduction and a Tax Credit?
So what’s the big secret to paying less tax? It’s simple: claim every tax deduction and tax credit that you’re eligible for. Deductions and credits can reduce the total amount of income tax you have to pay. Here’s the difference between the two:
A tax deduction reduces how much taxable income you claim. A tax credit reduces how much tax you owe dollar for dollar.
Tax deductions reduce the amount of your income that’s subject to tax. For instance, if you contribute $2,000 to a traditional retirement account, you generally are allowed to deduct that amount from your income. In other words, if your gross income is $50,000, having a $2,000 deduction means that you’re only taxed on $48,000. That would save about $500 in federal taxes for a single filer in 2013.
Tax credits are even more powerful than deductions because they reduce the actual amount of tax you must pay. For instance, if you’re a single filer in 2013 with gross income of $50,000, you pay about $8,000 in taxes. However, if you qualify for a $2,000 tax credit, you only have to pay $6,000.
So, a tax deduction reduces how much taxable income you claim. A tax credit reduces how much tax you owe dollar for dollar. In other words, having a $2,000 tax credit actually saves you $2,000, while having a $2,000 tax deduction only saves you a percentage of that amount based on your effective tax rate.
Some tax credits are even refundable, which means they can reduce your taxes below zero and allow you to get a tax refund.
5 Common Tax Credits for 2014
In this episode, we’ll cover 5 common tax credits that you might qualify for in 2013 and 2014. Then in Part 2 of this series, you’ll learn how to take advantage of every possible tax deduction for your situation:
Credit #1: The Saver’s Tax Credit
The Saver’s Tax Credit is an incentive to save for retirement. It repays you as much as $1,000 (or $2,000 if you’re married filing jointly) when you save for the future, which is a very nice benefit.
This credit is available for low- and moderate-income workers and those who are self-employed who contribute to a retirement account, such as an Individual Retirement Arrangement (IRA) or a workplace plan, like a 401(k) or 403(b). To claim the Saver’s Tax Credit you can’t be a dependent on someone else’s tax return, be younger than 18, or be a full-time student.
While the deadline for funding workplace plans is generally December 31, there’s more time with an IRA. You have until tax day, which is typically April 15, to add money to a new or existing IRA, for the prior tax year.
To find out how much the Saver’s Tax Credit could put in your wallet, use this handy chart or follow instructions on Form 8880.
Credit #2: The American Opportunity Tax Credit
The American Opportunity Tax Credit helps you pay for college expenses, such as tuition, fees, and books. It’s worth up to $2,500 per eligible student for the first 4 years of higher education.
This credit helps low- and moderate-income students who are pursuing a degree and are enrolled in school at least half time. You can’t double up and also claim another type of education credit, nor can you have a felony drug conviction to be eligible for it.
To find out if you can claim the American Opportunity Tax Credit use the IRS education calculator or follow instructions on Form 8863opens PDF file .
Tax Credit #3: The Earned Income Tax Credit
The Earned Income Tax Credit (EITC) was created to help low-income working individuals and families manage the burden of taxes. In general, if you earn less than about $51,000 this tax credit can give you a substantial tax refund.
The IRS has a calculator called the EITC Assistant in English and Spanish to help you find out if you qualify. They also have tax credit calculators for prior years.
If you find out that you were previously eligible for the EITC, but didn’t claim it, you can file an amended return. To correct a tax return, you must file Form 1040Xopens PDF file within 3 years after the due date of your original return.
Tax Credit #4: The Child and Dependent Care Credit
The Child and Dependent Care Credit helps you pay someone to care for those who depend on you, so you can work or look for work. It could be a child under the age of 13, a disabled spouse, or an older person who lives with you.
This credit is worth up to 35% of your qualifying care expenses, depending on your income. When figuring your credit, you can claim up to $3,000 of costs for one qualifying dependent, or up to $6,000 if you have 2 or more.
To claim the Child and Dependent Care credit complete Form 2441.
Tax Credit #5: The Child Tax Credit
The Child Tax Credit helps families pay for the cost of supporting children. It’s worth as much as $1,000 per qualifying dependent, depending on your income.
To claim a child, he or she must be younger than 17 and have lived with you for more than half of the tax year. To learn more or to claim the Child Tax Credit use Form 1040 (Schedule 8812)opens PDF file .
I know taxes aren’t the most fun or fascinating financial topic. Even Albert Einstein said, “The hardest thing in the world to understand is the income tax.”
But no matter what we think of them, taxes are here to stay. So join me next week for Part 2 of this series when I’ll give you a simple way to make sure you never miss a money-saving tax deduction.
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Man Protected from Taxes image courtesy of Shutterstock
About the Author
Laura Adams received an MBA from the University of Florida. She’s an award-winning personal finance author, speaker, and consumer advocate who is a frequent, trusted source for the national media. Money-Smart Solopreneur: A Personal Finance System for Freelancers, Entrepreneurs, and Side-Hustlers is her newest title. Laura’s previous book, Debt-Free Blueprint: How to Get Out of Debt and Build a Financial Life You Love, was an Amazon #1 New Release. Do you have a money question? Call the Money Girl listener line at 302-364-0308. Your question could be featured on the show.