Tax deductions vs. Tax credits: A guide for simplifying your tax filing experience
Article Published by: cnn.money.com
If the thought of filing your taxes gives you heart palpitations and sweaty palms, fear not.
Yes, taxes can be complicated. But the more you understand, the smoother the process will go.
Familiarizing yourself with these common tax terms should make hitting the April 17 deadline a little easier:
The forms: 1040, 1099 W4 and W2
There are many forms when it comes to filing taxes, but most people likely only have to worry about the basics: the 1040, W-2 and W-4.
The 1040 is your individual income tax return form: It’s where you report all your income as well as claim any deductions and credits. It’s lovingly referred to as “the long form.”
But there’s a shorter version too. If you have an even simpler tax situation, you might be able to use the 1040EZ. Check out the IRS’s qualifications checklist here.
Self employed or make some money on Wall Street last year? In addition to using the long form 1040, you’re going to need file a 1099. These documents detail any income you received outside of your employer. Income from interest and dividends, retirement account withdraws and self-employment income will all need to be documented on a 1099 form.
The W-4 is the form you use to tell your employer how much federal income taxes should be taken out of your paycheck. Employees should submit the form to their employer at the start of their job and update after any personal or financial changes.
And finally, the W-2: This is the form your employer sends to the IRS at the end of the year that shows how much money you made, along with how much taxes were withheld (both state and federal).
Step one to filing your taxes: selecting the right status.
The are five filing options: single, married filing jointly, married filing separately, head of household and qualifying widow/widower with dependent child.
It’s important to chose the right status since it will affect how much you owe. Many tax programs will walk you through which status to choose. Click here to read up about the different statuses.
You can qualify to file under more than one status, so pick the one that means paying the least taxes.
Uncle Sam gets a slice of your paycheck — there’s no (legal) way around that. Your withholding allowance is how much income tax an employer takes out of each paycheck and then sends to the government.
How much you have withheld is determined by many factors, including whether you’re married or have children.
Having too much withheld is like giving Uncle Sam an interest-free loan. But if you have too little withheld, you could end up facing a big tax bill come April.
The withholding tables recently changed thanks to the new tax code, so make sure you aren’t having too much or too little held from you paycheck. You can use the IRS withholding calculator here.
Deduction vs credit
No wants to pay more than they have to. That’s why you should take advantage of all the tax credits and deductions available to you.
A credit reduces the amount of taxes you owe dollar for dollar. That means a $5,000 credit saves $5,000 in taxes. There are two types of credits: refundable vs non-refundable. When it’s refundable, it means you can still get a refund from the government, even when your federal income tax bill is zero.
Deductions, on the other hand, can lower how much of your income is subject to taxes, and are equal to the percentage of your marginal tax bracket. So if you fall into the 25% tax bracket, a $5,000 deduction saves $1,250 in tax.
Standard deduction vs Itemized deductions
Remember we said the goal of filing your taxes is to pay as little as legally possible? Listen up. You can either file for the standard deduction or itemize your deductions.
The standard deduction lowers the income you are taxed on by a set amount. For 2017, the standard deduction is $6,350 for single filers and $12,700 for married filing jointly.
Itemizing deductions means you declare your individual deductions (like mortgage interest, charitable donations, etc.) to reduce your taxable income. It only makes sense if the deductions you qualify for exceed the amount of the standard deduction. Only about one-third of tax filers itemize.
Adjusted gross income vs taxable income
Your adjusted gross income is your total income for the year, minus certain adjustments that the IRS allows. This number is used to determine your tax bracket.
Your taxable income is the total amount of income that is subject to income tax. This includes your salary, but also adds things like bonuses, tips, alimony, profits from stock and real estate sales and gambling winnings.
Make a profit selling some stock? Uncle Sam is going to get a piece.
You will face a capital gains tax when you sell something for a profit, whether a stock, property or a car. The profit is considered a capital gain, which has its own tax rate. Likewise, you can claim a capital loss on an investment you lost money on, which will reduce your tax bill.
ABOUT MICHAEL SMERIGLIO:
Michael Smeriglio III is a financial specialist. A licensed CPA since 1985, Mike has been providing tax preparation services to individuals and businesses for more than 30 years through his firm located in Greenwich, CT.