*The following is based on scenarios encountered in the United States, subject to the income tax system of the United States as of the time of this post. These ideas might not apply to you depending on where you live and work*
Previously, I covered how you can reduce the amount of taxes you pay to the government by owing taxes when you file your return. The way that works is by taking advantage of tax credits. Some credits are refundable, but others are non-refundable. Refundable credits are tax credits that kick money back to you, period. If you owe $300 at tax time, but you are getting a $400 credit, you get a $100 refund. If you are already getting a $300 refund, but you are getting a $400 tax credit, you get a $700 refund.
Non-refundable credits are different. If you owe $300 at tax time, and you’re getting a $400 non-refundable tax credit, then you owe $0, but you also don’t get a refund. If you are already getting a $300 refund, and you qualify for a non-refundable $400 tax credit, you can’t utilize the credit at all, and you still just get your $300 refund.
Since you can only take advantage of non-refundable tax credits if you owe additional taxes at tax time, it’s important to try to strategically owe more taxes and utilize the maximum amount of tax credit possible for your situation (if your goal is to pay the least amount in taxes per year). There’s another reason why utilizing credits is so important. They save you more money than deductions.
Imagine you made $20,000 in a year. Your taxable income is $20,000 without claiming any deductions, exemptions, or credits. If you were to claim a $12,000 deduction, your taxable income would then be $8,000. But that is not the same as saying that the deduction saved you $12,000. You weren’t going to pay $12,000 in taxes. It just reduced the amount of money upon which you were going to be taxed. Before the deduction, if your tax rate is 10% for the ease of this example, you would have owed $2,000 for the year. But 10% of $8,000 is $800. So the deduction dropped your tax liability from $2,000 to $800, a savings of $1,200. A $12,000 deduction doesn’t save you $12,000, it reduces your taxable income by $12,000. The amount a deduction saves you is equal to the difference between the tax liability calculated from your taxable income before the deduction minus the tax liability calculated form your taxable income after the deduction.
Credits, on the other hand, reduce the amount you owe. While every $1 deduction decreases your tax liability by $0.10 at a tax rate of 10%, a $1 tax credit decreases your tax liability by $1. So a $4,000 tax credit is more valuable to you than a $4,000 deduction, but only if you are able to utilize that credit.
Ideally, you want to maximize your deductions and maximize your credits. In order to do that, you will need to max sure you don’t overpay throughout the year, so that you aren’t owed a refund at tax time. Keep in mind that this strategy will be less useful to you if you do not qualify for any non-refundable credits at tax time.
Lance Out Loud 