How to Pay Less Tax Using Deductions and Credits
Find out which tax deductions and credits can really save you money.
Laura Adams, MBA
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How to Pay Less Tax Using Deductions and Credits
This is the first post in a three-part series we’re calling Tax Boot Camp—because Uncle Sam wants you, but he also wants your money!
How to Pay Less Tax Using Deductions and Credits
Taxes are a part of life, but no one (at least no one I know) wants to pay more than their legal share. So you Boot Camp recruits can call me Sergeant Adams for the next few weeks. I won’t scream for pushups or tell you that you can’t handle the truth, but I will expect you to pay close attention. Taxes certainly aren’t the most stimulating personal finance topic out there, but if you don’t go AWOL on this Boot Camp series, you’ll learn how to pay less tax, save more money, avoid getting into trouble with the IRS, and get last-minute filing tips that’ll keep you calm and cool.
What Do You Need to Know About Tax Deductions?
In this first episode of the series, I’m going to cover what you really need to know about tax deductions and tax credits. Why should you care about them? Well, because they can cut your tax bill or even increase your tax refund! A true tax warrior fights to claim every single deduction and credit that they qualify for so they never pay more tax than they absolutely have to. So let’s start with deductions.
A tax deduction is an amount that the IRS allows you to subtract from your taxable income. When you reduce your taxable income, you lower your tax liability. For example, if your taxable income is $40,000 and you’re eligible to claim $10,000 in allowable tax deductions, then you only have to pay tax on $30,000—not $40,000. That makes a huge difference!
Should You Take the Standard Deduction?
The trick with claiming tax deductions is that to be eligible for some of them, you have to “itemize” your deductions. Itemizing isn’t nearly as complicated as it may sound. Here’s the deal: There are two ways you can file your tax return—by itemizing deductions or by taking a standard deduction. Itemizing simply means that you list each deduction on a form called Schedule Aopens PDF file and submit it with your tax return.
The standard deduction is a fixed amount of deductions based on your tax filing status, and it can change from year to year. You get to choose the option that gives you the lowest tax bill and saves you the most money! For instance, if you’re a single taxpayer, your standard deduction for 2010 is $5,700. If you can come up with more than $5,700 in total allowable deductions to itemize, you’ll save more money by itemizing than you would by claiming the standard deduction.
Why Do Some People Overpay Taxes?
It’s important to remember that lots of people overpay taxes every year because they’re just too lazy to keep up with their deductions. I’ll admit that taking the standard deduction is easy because you don’t have to gather any records or do any calculations on Schedule A. But since you listen to Money Girl, you know that taking the easy route doesn’t necessarily save you money! Always figure your taxes both ways and pick the method that lowers your tax bill the most.
What Are the Itemized Tax Deductions?
The best way to learn about all the potential deductions to itemize is to look at Schedule A. For 2010, the itemized deductions include the following:
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Taxes you paid for state income taxes, sales taxes, real estate taxes, and certain motor vehicles
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Charitable gifts to qualified organizations
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Casualty and theft losses
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Job expensesopens PDF file that are not reimbursed by your employer
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Tax preparation fees
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Safe deposit box fees
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Interest you paid for investments and for a home mortgage, including points and mortgage insurance premiums
As a side note, I’ve been getting lots of questions lately about claiming the home mortgage interest deduction, so I created a short video with information and frequently asked questions to help you understand who’s eligible to claim it. When you sign up at SmartMovesToGrowRich.com you can watch this video and get e-mail updates from me.
Be aware that some of the deductions are limited based on your income. For example, you can only deduct the amount of your medical and dental expenses that exceed 7.5% of your adjusted gross income. Schedule A walks you through all the rules that apply for each itemized deduction.
Tax Deductions You Can Take Without Itemizing
But what if you don’t have enough deductions to make itemizing pay off? Don’t worry, there are deductions you can take when you claim the standard deduction, too! They’re listed on Form 1040opens PDF file in the section labeled Adjusted Gross Income. They include the following for 2010:
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Traditional IRA contributions up to a maximum of $5,000 (or $6,000 if you’re age 50 or older)
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Health Savings Account contributions up to a maximum of $6,150 when you have a high-deductible health plan
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Moving expensesif you’re relocating more than 50 miles for a new job
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Alimony you paid
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Educator expenses up to $250
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Business expenses for government workers, reservists, and performing artists
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Student loan interest up to $2,500
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Tuition and fees paid to a qualified institution up to $4,000
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Self-employment expenses, such as one-half the self-employment tax; contributions to a SEP, SIMPLE, or qualified retirement plan; and health insurance payments
Okay, this isn’t a complete list, but it should be enough information to help you know if you can save money using tax deductions whether you itemize or claim the standard deduction. You’ll find links to much more information at the bottom of this post.
What You Need to Know About Tax Credits
Now, let’s switch gears and talk about another way to legally reduce your taxes—tax credits. I love tax credits because they’re even more effective at slashing taxes than deductions. Here’s why a tax credit can be more valuable than a deduction: A tax deduction reduces the income on which your tax is calculated. But a tax credit cuts your actual tax bill dollar for dollar. For instance, if you owe $1,000 in taxes, getting a $600 tax credit means you save that full amount and only owe $400.
What Tax Credits Can You Claim?
The following are credits that you may be eligible to claim for 2010:
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Child and Dependent Care Creditopens PDF file pays up to $6,000 for the cost to pay someone to care for your children under the age of 13 or adult dependents, so you can work or look for a job.
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Child Tax Creditopens PDF file pays up to $1,000 per eligible child you have under the age of 17.
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American Opportunity Tax Credit pays up to $2,500 for the cost of qualified expenses for higher education through 2010.
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Lifetime Learning Credit< pays up to $2,000 for coursework at a qualified institution.
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Homebuyer Credit pays up to $8,000 for a home that was purchased by September 2010.
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Residential Energy Credit pays 30% of the cost of certain energy-efficient improvements you make to your home in 2009 and 2010 up to $1,500.
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Retirement Savings Contributions Credit helps low and moderate-income taxpayers who make contributions to a retirement plan.
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Earned Income Tax Credithelps low and moderate-income taxpayers depending on their income and family size. This is one of the most overlooked tax benefits, and it can result in a tax refund of over $5,000.
I hope this first installment of Tax Boot Camp has taught you something you didn’t know about tax deductions and credits. Again, this isn’t a complete list. If you have questions about your tax situation or feel too overwhelmed to file your own return, be sure to hire a qualified tax preparer or accountant. They can save you more money than they cost when they help you maximize tax benefits that you’re eligible for.
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More Resources:
Form 1040, U.S. Individual Income Tax Returnopens PDF file
Schedule A, Itemized Deductionsopens PDF file
Publication 502, Medical and Dental Expensesopens PDF file
Publication 936, Home Mortgage Interest Deductionopens PDF file
Publication 936, Charitable Contributionsopens PDF file
Publication 529, Miscellaneous Deductionsopens PDF file
Publication 590, Individual Retirement Arrangements (IRAs)opens PDF file
Publication 969, Health Savings Accounts and Other Tax Favored Health Plansopens PDF file
Publication 521, Moving Expenses
Publication 970, Tax Benefits for Educationopens PDF file
Publication 535, Business Expensesopens PDF file
Publication 4819, First-Time Homebuyer Credit
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.