Ep. 57 | Tax Deductions vs. Credits
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Speaker 2:Hey, everyone, and welcome back to the Teaching Tax Full podcast. Today on episode 57, we are gonna do a direct comparison between tax deductions and tax credits. So hopefully, by the end of this, you'll have a better idea of the differences, as well as, maybe you've been going about it a little bit the wrong way with some of these. So before we do that, as always, let's take a quick moment and thank our sponsor.
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Speaker 2:Hey, everyone, and welcome back to the Teaching Tax Flow podcast. Today, we are gonna answer or I should say discuss and dive deep into the question we get asked a lot where some people are frankly a little confused. You know, what is the massive difference between a tax credit and a tax deduction. So as always, I bring the smartest person I know to the table to hit this topic for us, Chris Pacuro. How we doing, brother?
Speaker 4:John, I am doing great. Welcome back to the Teaching Tax Slow podcast, everybody. We appreciate you giving us a listen. And just wanted before we jump into this topic, we we did our one year anniversary show a couple weeks ago, but just from the bottom of our hours, really thank you, the Teaching Tax Flow community, for making this community what it is. And, without without your listenership, without your support, we we wouldn't we wouldn't do this.
Speaker 4:We wouldn't do this podcast. And, and feel free to share it with people. Feel free to continue to give us suggested topics. And this came from, the defeating taxes private Facebook group. People were a little confused over the difference between a federal tax deduction and a federal tax credit.
Speaker 4:So we wanna talk through a couple similarities, but also the main differences. Absolutely. And there there is a very defined difference between
Speaker 2:the two of them. And in full transparency, Chris, I even find myself sometimes, you know, again, not being a tax professional day in and day out like everybody here. I sometimes get even get confused. So there is kinda some I wouldn't say gray area, but, you know, a little bit of the choppy waters, we should say. So I'll let you kinda run with this.
Speaker 2:Where where's the best place to start if somebody were to come to you and say, hey. I, I just got all these credits. And, you know, and your response is like, well, you know, no. They're not those aren't credits. Those are deductions or vice versa.
Speaker 2:So how would you explain this, we'll say, to, to a classroom of college students?
Speaker 4:The federal tax deduction and the federal tax credit, they can both help you quite a bit on your tax return, in legally and ethically reducing the tax you pay in your lifetime. And both of them provide you with tax planning opportunities. That so there are some big similarities. A federal tax deduction is reduces your taxable income and it's subtracted from your total income when we calculate the tax that you owe. So an exam common example of a federal tax deduction would be mortgage interest, real estate taxes, charitable contributions.
Speaker 4:Now those are all federal tax deductions. What we now in those cases, those are called itemized deductions. And each taxpayer receives what's called a standard deduction. We have some more another another podcast on that, and you what you do is you add up your itemized deductions, and if your itemized deductions exceed your standard deduction, then you take advantage of your itemized deductions at your federal tax return. So that's where sometimes things get confusing because someone might say, hey, I've got a deduction.
Speaker 4:If I donate x to this church, do I is that a deduction? Yes. It's a deduction. Can that person actually use it? It depends on their fact pattern.
Speaker 2:And that can actually cross over too into medical expenses if I'm not mistaken. Right? We actually did that on a previous podcast where somebody might be keeping, you know, records, say they're you know, they get a prescription or or anything, a small amount of medical expenses, and they think, oh, wow. I need to I need to keep this handy because I'm actually gonna get this money back. Well, not really because they you know, like you was mentioned, we we kinda weigh the difference or weigh the options of that standard deduction versus itemized.
Speaker 4:So if anybody hasn't heard that, go back and listen to that podcast as well. Correct. So, like, medic and some deductions are limited. You mentioned medical expenses are limited. Only the amount that exceeds seven and a half percent of your adjusted gross income are an itemized deduction, and they you only get to take advantage of those on a federal level.
Speaker 4:Some states do allow you to itemize, so we wanna keep that in in mind, if you itemize your deductions. Now let's talk about businesses and rental properties. A deduction is anything that's or is it you can deduct off of your income any ordinary and necessary expenses. So for instance, John, as in a podcast company or production company, for us, we could deduct the cost of our subscriptions and softwares to put this podcast on, the cost of our equipment that we purchase for the podcast because those are ordinary and necessary in our line of business. And what you have to remember as a deduction, like you mentioned, John, is in a dollar for dollar tax benefit.
Speaker 4:So let's give you let's use an example. Let's say someone is in the 24% marginal tax bracket. Let's use a personal expense. They, they contribute to an IRA. And let's say it's a married couple.
Speaker 4:Okay? And they put a total of $10,000 in their traditional IRAs at the 22% marginal tax, bracket. What would happen is they would get a $2,200. So it's a $10,000 multiplied by their marginal tax rate. We know that that's your most important KPI when tax planning, and their tax benefit would be $2,200.
Speaker 4:Their tax benefit's not $10,000. 10 thousand dollars is their outlay of cash. Back to tax flow versus cash flow. Now a $2,200 tax reduction or tax benefit is nothing to sneeze at. That's that's still significant.
Speaker 4:So that's how a federal tax deduction works. It the so the first thing you have to consider is when you think about an expenditure, and we say don't let the tax tail wag the dog, the first thing you have to consider would be one, is this deduction is this expense that I'm I have in my life, could be medical, it could be charitable contribution, is it a federal tax deduction? Yes. If it's a business, if it's is it ordinary, necessary? If it's deductible or a deduction, can I actually use it on my personal tax return based on my fact pattern?
Speaker 4:That's the next hurdle they have to jump over. Is it gonna give me a benefit? If it gives you a benefit, great. The third step is how much is that benefit? Take the deduction and multiply it by your marginal tax rate, and that's your tax benefit from the deduction.
Speaker 2:Right. Right. And some of this does get kind of, I guess, overwhelming. I guess, confusing could be the word too where some people you know, again, you look at it and it's one of those things, you know. Maybe don't be embarrassed if you don't know the difference.
Speaker 2:That's why we're here. Right? That's why we create this. I mean, we're not all we're not all, what's the term I'm looking here for? Like, off the top of the head, like, this is exactly what it is.
Speaker 2:Like, mister Pacura over here. You know, sometimes we get a little, like, you know, we get a little confused on it. I know, Chris, you did a great job of explaining this, and I've heard it so many times. I'm trying to remember exactly where it was, but I I feel like it was on one of our podcast, but then also on an event that we did or webinar with with somebody else couple months ago. And I feel like it comes up with conversations is, you know, talking about the garage sale versus donation and, you know, the time and and resources that go into things and, you know, is it really worth it?
Speaker 2:Obviously, if you donate, you know, you're you're doing some good for humanity. We could say it in one way. But really, if are you is it really worth your time to be holding on to the donation, receipt, if you will, from Goodwill for, you know, eleven and a half months if, you know, the January, you get a bug up your rear and you say, oh, you know, I'm gonna donate everything because this is gonna help me next year. You really have to weigh those options. So if you had to kinda sum it up too before we get into, you know, a little bit more on the credit side, what would be the biggest and easiest but most condensed comparison between credit versus deduction?
Speaker 2:Just to kinda reiterate it for everybody here if that's something we could do. Almost like a one liner. Right? Like an elevator.
Speaker 4:The one liner would be effect. A a deduction reduces your taxable income. A credit reduces
Speaker 2:your tax. Bingo. That's a great way. You know what? And kudos to you for putting it in a one line.
Speaker 2:That's like somebody asked
Speaker 4:me to describe to do that. I've I've gotta accept
Speaker 2:That just fell off the tongue, man. That was that was very impressive. So if anybody also hasn't heard this, it's almost like asking Chris to sum up like, hey. Tell me tell me what a $10.40 is in one line and and why I should use it. It's like somebody asking me a marketing question and them expecting, you know, a ten second response and then thirty five minutes later, we're still talking about the same thing.
Speaker 2:So great job on that. So if let's kinda shift gears if you're okay with that and talk a little bit about credits. I know we just did a podcast on this as well. There's a lot of credits out there. I know it's a term that a lot of us see in Facebook ads, radio ads, TV ads, like credits kind of that big sexy term that is very attention grabbing, if we will, that marketers use.
Speaker 2:Right?
Speaker 4:Yes. So a federal tax credit is a dollar for dollar reduction of the actual amount of tax that you owe. So it directly reduces your tax liability. So for instance, if your income was a hundred thousand dollars and your tax was $15,000 and you had a $1,000 energy efficiency credit that you're eligible for, then your tax would go down to $14,000. That's what you have.
Speaker 4:So, in general, credits are better than deductions. So that that's that's what you have to look at. Now common credits, at least on the personal side of things, there are several different business credits that we that go beyond the scope of this podcast or this episode. I shouldn't say our podcast because we've talked about a lot of research and development and, gosh, there's just so many, or, employee retention tax credit. But don't worry about those.
Speaker 4:Let's talk about personal tax credits right now. The most common personal tax credits are gonna be for educational expenses, childcare expenses, adoption, energy efficient home improvements, and vehicle purchases. And, really, what's interesting is for the credits for energy and vehicle changed dramatically with the passing of the inflation reduction act. We talked that about the tax agencies are are involuntary business partners and tax laws are written to encourage and discourage certain behavior. So with the passing of the IRA or inflation reduction act, that really opened up a lot more opportunity for vehicle, for the first time ever, used vehicle credits and energy efficiency credits in your home in business, but let's talk about the the personal side right now.
Speaker 4:What is that why why am I talking about that right now? Well, the reason is is congress wants us to be more green. So they're gonna incentivize us financially to invest in more green, assets. So they're trying to not only influence financial behavior, but social behavior as well by giving us tax incentives.
Speaker 2:I will see a similar trend here. It's almost like us parenting a toddler. Right? You incentivize them, say, yeah. We'll let you have some of your Halloween candy you got, but you have to clean up all of your landmines that you set all over my living room by way of, you know, Legos, dolls, things that, you know, will take out the parents.
Speaker 2:So it's you mentioned that too. So a lot of these credits are really I mean, obviously, they're put place, by congress and really by I r by the IRS. Mhmm. So they are in their eyes, credits are just that. They're put in place to incentivize change or entice us to do things like you mentioned with vehicles.
Speaker 2:So green energy, we talk a lot on that solar, etcetera, etcetera.
Speaker 4:And but you are self Yeah. And there are some expenses. There are some expenses on the personal side of things that could be a deduction or a credit. And that's where tax planning and strategy comes in quite a bit. The the most the two most common examples would be childcare and educational expenses.
Speaker 4:They could be a deduction or they could be a credit. And depending on your adjusted gross income, your filing status, the amount of your expenditures, One might be better than the other. The rule of thumb is gonna be your credit's gonna be better than the deduction, but that isn't always the case. One more thing to consider with credits. We have different types of credits here, in the tax code.
Speaker 4:We have refundable or and nonrefundable. That's interesting. So examples, I mean, some of the larger credits that were refundable were, let's say, adoption credits, but let's talk about refundable versus nonrefundable. What nonrefundable means is this. Let's say that you have a married couple.
Speaker 4:They have $60,000 of income. They have, you know, a couple of dependents, so they're getting the child tax credit, but their net tax is $4,000. Yet they qualify for $6,000 worth of credits. Unfortunately, they fortunately, they would wipe out all their tax, so they have zero tax. But those additional two credits, $2,000 worth of credits, it's not like cell phone minutes and then in the nineties, John.
Speaker 4:They don't roll forward. They go bye bye. So you don't which that's a nonrefundable credit. A refundable credit means even if you don't have taxed to that you're offsetting with the credit, you would still get a refund for the credit. So refundable credits are better than nonrefundable, and there are some credits out there that are nonrefundable yet carry forward.
Speaker 4:There's a specific solar slash energy credit that does that so that if you were to so so if you were to let's say you have Joe and Jill, tax flow taxpayer. They have their tax liability or their total tax is $15,000 for the year. They invested in solar, and they have a $30,000 credit on their federal tax return. They spend a hundred thousand dollars on solar. They get a $30,000 tax credit.
Speaker 4:The the $1,515,000 dollars of the credit would wipe out all their tax for the current year. The remaining amount could be carried forward, and some some could be carried forward and back. But, what we want people to understand here is, yes, tax deductions and tax credits are similar because they help you. They can be limited based on your situation, and some deductions could be either a credit or a deduction, and then some credits are refundable or nonrefundable. Make sure that you read through the tea leaves and figure out what what type of consumer behavior is being incentivized by tax credits.
Speaker 2:And those refundable credits are like the, that's basically the unicorn. That that's, like, that's pretty much the most beautiful thing you could come across. But, obviously, they're not something that's just handed out. Right? They're not just throwing these things from a car window.
Speaker 2:You it like, you use the example of solar. Right? Solar is a pretty hefty investment for somebody's home or or even on the commercial side. So it's you have to you have to weigh the benefits. And we we won't go to the detail on that as a whole, but that's actually a a great comparison.
Speaker 2:So really looking at the examples we gave. Right? We have the refund and kind of going backwards. So we have refundable credits, which are incredible, obviously. There are other credits that are nonrefundable, and then we have deductions.
Speaker 2:So really looking at this and just understanding them. In And one thing
Speaker 4:I'm gonna we're gonna end on it because I wanna give people a little bit of, something to think about when they look at their tax return. The most common refundable credits are gonna be your earned income tax credit, your additional child tax credit, so both family related. American opportunity tax credit that's really out there to help with qualified educational expenses, and premium tax credit. Be aware that many of the credits do phase out based on income. So definitely look at your tax return.
Speaker 4:Make sure you're taking advantage of those credits, and let us know if you have any questions.
Speaker 2:Excellent. Excellent. And I'll I'll kinda pose a question pose a challenge to our listeners here as well. We did mention marginal tax rate a little bit earlier in this recording or MTR as it's commonly referred to. So if you if you're not familiar with that, don't, don't blow it off.
Speaker 2:Actually, take some time. Look it up. Again, we mentioned it on almost every podcast we do. So check that out. MTR, that's your marginal tax rate, which by the way is not your tax bracket.
Speaker 2:So if if that really confused you, definitely check it out. You'll thank us later. So in that terms, the thank you again, Chris, for for going over this with us. I know this is something that we kind of allude to or touch on briefly every once in a while, so I thought it was perfect timing that we heard through this question a few times from community members, made some great content for this show as well. And we'll be talking about this as always too.
Speaker 2:And just one more thing too, is everybody be sure to kind of keep up on this as as the as the years go on too because they do change. Right? As we mentioned, some credits are here today. They'll be gone next year and vice versa. So as always, we will see everybody here same time, same place next week.
Speaker 2:Hey. John Topolsky here from the teaching tax flow team. Still here. Can't get rid of me that easy as I always like to say, but hopefully, you got some good information from this show. We do get a lot of questions on this, believe it or not, and it's totally okay.
Speaker 2:It's just one of those things. Right? Like, tax deduction, tax credit. Sometime there's a little bit of we could say misinformation or just plain old confusion between the two of them. So we're glad we got to touch on this topic.
Speaker 2:Hopefully, now for those of you that had a lot of questions regarding the differences, now it's pretty clear to you which is which. So as always, keep shooting us those questions, those ideas. We love hearing them. That's what feeds this show. So until next time, keep on tax planning.
Speaker 2:That's right. Keep on tax planning. If you're not familiar with what that term tax planning means, shoot us a message. Check out our other content. Tons and tons of information on that as well as a masterclass that we actually just did on that topic.
Speaker 2:So be sure to check out, I believe it's on our Facebook and LinkedIn page as a direct link to replay that masterclass. So check it out, and we will talk to everybody very soon.
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