Understanding Tax Deductions, Tax Credits, and Tax Audits
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Deductions and credits are often confused because they both lower your bill by “adjusting” your income. The difference is how they are doing it and which part of the filing process they apply to.
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Standard deduction vs. itemized deduction
There are two types of deduction: standard and itemized. You do not actually pay tax on your full earnings. The government allows you to deduct a particular amount of your income. The income you deduct is exempt from tax.
The main deduction is the standard deduction and each taxpayer qualifies for it. Most people use the standard deduction, but many tax filing services can tell you which type of deduction is better for you once you provide your tax information. Your standard deduction depends on your filing status and everybody in the filing status gets an equivalent standard deduction (though seniors and other people who are blind get more). The standard deduction updates annually to stay at pace with inflation. (Before the 2017 tax reform, there have also been personal exemptions, which each tax filer could take. Exemptions are eliminated, starting in 2018.)
2020 standard deductions
These standard deductions below apply to your 2020 taxes, which you enter early 2021. there's a further deduction of $1,300 for married filers if either person is over age 65 or blind. Single filers and heads of the household get a further $1,650 if they’re blind or over 65. you'll claim double the extra deduction if you’re both blind and over 65.
2021 standard deductions
These standard deductions below apply to your 2021 taxes, which you don’t file until early 2022.
Itemized deductions
You can prefer to itemize your deductions rather than taking the standard deduction if you spent more than your standard deduction during the year on expenses. Only about 10% of all Americans are going to be ready to itemize. Possible itemized deductions include:
Medical expense deduction for medical expenses that exceed 10% of your adjusted gross income
Up to $10,000 in SALT (State and local tax) deduction
Mortgage interest deduction for interest and points on your home mortgage
Charitable contributions
Casualty and theft losses from a federally declared disaster.
If you don’t itemize, you'll still be able to increase your standard deduction by any net qualified disaster losses. Other expenses, including gambling losses, amortizable bond premiums, and a couple of others that aren’t quite common.
How tax deductions work
A tax write-off effectively decreases your income for the year. If you have $55,000 in gross income (total income) and qualify for $15,000 in deductions, your taxable income is now $40,000 ($55,000 minus $15,000).
Deductions are often divided into above-the-line and below-the-line deductions. The “line” is your AGI (adjusted gross income). First, there's a group of above-the-line deductions that lower your gross income. you'll find these on Schedule 1. Examples include the scholar loan interest deduction and also the deduction for self-employment tax. Everyone can take these above-the-line deductions if they’re eligible.
You reach your AGI after taking above-the-line deductions. Then you subtract the quality deduction. If you're itemizing, you subtract those instead, and they’re considered below-the-line deductions.
Even if you don’t itemize, you'll still qualify for one below-the-line deduction: the qualified business income (QBI) deduction. The QBI deduction is out there to several owners of sole proprietorships, partnerships, and S corporations, also as some trusts and estates.
The result after taking all deductions is your taxable income. this is often the income the IRS uses to calculate what proportion of tax you really owed for the year. Deductions don't directly reduce what proportion of tax you pay. They reduce the quantity of income wont to determine what you owe.
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How tax credits work
Tax credits lower the amount of taxes you owe. There are two main kinds of credits: refundable and nonrefundable.
Refundable credits can reduce your liability below $0, meaning that you simply can get a refund albeit you don’t owe any tax for the year. For instance, if your liabilities are $15,000 and you've got $17,000 in refundable credits, you'd get a $2,000 refund from the government.
Nonrefundable credits are limited to your liabilities and don’t bring your liability below $0. For example, if the credits you qualify for are worth more than what you owe, your bill simply drops to $0 and you don’t get a refund.
Tax credits that you might qualify for include:
Learn about other types of tax credits that might be applicable to you below.
tax credit infographic from thesimpledollar.com
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Why do we get tax audits?
A tax audit happens when the IRS requests more details about your income tax return to verify that everything you reported was correct. The word “audit” strikes fear into the hearts of many people, but they really aren’t that bad for many.
What causes an audit?
First of all, audits aren't very common. They typically occur when something on your return is out of the standard, like saying your income doubled from one year to subsequent or reporting no charitable contributions one year then $100,000 of charitable contributions subsequent year. The IRS randomly audits a small percentage of individuals, but these aren’t common enough to be scared of.
The IRS won't audit you for little mathematical errors. If you write an income of $10,050 rather than $10,005, the IRS typically just corrects that error without even mentioning it to you (unless it changes your refund/bill).
If you forget to connect a document to your return and therefore the IRS needs it, you'll get a letter asking you to send it in. This isn’t an audit and you don’t need to worry about penalties for a little mistake like forgetting to connect a W-2.
Another thing to remember is that if you used a tax-filing service and there was a mistake on their end, the service will usually cover costs you incur from an audit. Some services also will represent you during an audit, though this might cost more.
How audits work
If the IRS does audit you, it'll notify you via a letter within the mail. This letter will have any instructions or other information you would like. In most cases, you only have to mail in some forms to verify that your return was accurate. These may include documents like medical receipts and pay stubs. This is often considered a mail audit.
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Now that you understand the terms and steps to file your taxes, learn what you should expect after filing.
Disclaimer: This article is written for the 2020-2021 tax year
Edited by Vanessa Wong
Guest Author Spotlight: Joyce Lam
Joyce is a Tax Site Supervisor for VITA program at IRS. She is also a founder of Kaimore, a nonprofit that promotes economic mobility by providing targeted professional development services for those who are underprivileged.
