A tax break is a benefit offered by the government that reduces your tax liabilities. A tax break is usually a credit or deduction that is made possible by tax laws. You can also get exemptions from your state or federal tax returns and exclude certain types of income from it.
Certain groups receive favorable tax treatment as well. For instance, churches and religious organizations are generally exempt from federal, state, and local income and property taxes. As a result of natural disasters, people are eligible for tax breaks such as filing extensions, penalty waivers, and deductions for loss due to casualty and theft.
What You Need To Know
- Your total tax liability is reduced by tax breaks like credits and deductions.
- In order to promote or strengthen the economy, tax laws are designed to provide tax breaks.
- The government also offers tax breaks to promote particular economic activities (e.g., a tax incentive for getting a secondary education).
- There are refundable tax credits that can reduce your tax liability below zero, resulting in a refund. Tax credits offset your tax liability dollar-for-dollar, and some can reduce your liability below zero and result in a refund.
- Tax deductions lower the amount of tax owed on gross income.
Taking advantage of tax breaks
Individuals and corporations can save significant amounts of money by taking advantage of government tax breaks. These tax breaks are known as tax credits, deductions, exemptions, and tax exclusions.
There are times when a tax break is available without any action on your part. The proceeds you receive from life insurance are generally not included in your taxable income, so you don’t have to report them to the IRS. However, you must meet certain eligibility requirements and claim the tax breaks you qualify for (e.g., tax credits or deductions) on your income tax return.
Up until 2017, the personal exemption deduction was a federal tax break. Under the Tax Cuts and Jobs Act, that deduction has been repealed (reduced to 0) for tax years 2018 through 2025.
By increasing the amount taxpayers spend and increasing businesses’ ability to invest, tax breaks can stimulate the economy. Moreover, tax breaks can promote certain behaviors that benefit society, such as replacing gas-guzzling cars with fuel-efficient ones.
Tax laws determine how tax breaks work, who qualifies, and (in some cases) how long the tax break lasts. As mentioned above, federal and state tax laws determine how tax breaks work. It is the responsibility of Congress and the president to approve federal income tax laws. In 2017, when then-President Donald Trump signed into law the Tax Cuts and Jobs Act (TCJA), which made significant changes to the U.S. tax code.
Tax Break Types
Credits for taxes
When you take a tax credit, you reduce your tax liability on a dollar-for-dollar basis, which has a greater impact than if you take a deduction, which reduces the amount of income you need to pay. You receive a tax credit if you owe taxes after taking all deductions from your taxable income. For example, if you owe $3,000 and are eligible for a $1,100 tax credit, then your tax liability is reduced to $1,900 ($3,000 – $1,100).
As far as tax credits are concerned, they directly reduce your tax bill. Tax deductions reduce your taxable income, which is the amount on which taxes are calculated. Tax credits are worth more than deductions, since they are calculated directly on your income.
There are also tax credits for corporations that can lower their tax bills. Credits such as business tax credits, investment credits, and child care credits for workers are implemented regardless of the industry or sector, since they benefit workers and the national economy. In addition, they may be industry-specific, such as those in agriculture, energy, and mining.
Deductions from taxes
Your taxable income can be reduced by subtracting expenses from your gross income—and therefore, the amount of your tax bill—if you take a $1,000 deduction. Depending on your tax bracket, the deduction has a different value. For example, if you’re in the 22% tax bracket, the $1,000 deduction would save you $220 ($1,000 × 22%) on your tax bill.
There are a number of deductions you can itemize, including:
- A mortgage interest deduction of $750,000 applies to the first $750,000 in secured mortgage debt (12 or $1 million if you bought the home before Dec. 16, 2017).
- AGI that exceeds 7.5% in unreimbursed medical and dental expenses
- State and local taxes up to $10,000
- Contributions to charities
- Losses due to casualties and thefts
- Losses from gambling
It makes financial sense to itemize if you can deduct more than your standard deduction.
Exclusions from taxes
A tax exclusion shields a certain portion or type of income from taxation. For example, child support payments, life insurance proceeds, and municipal bond income can usually be exempt from taxation. Additionally, federal income and payroll taxes are not charged on health insurance premiums that your employer pays, and the portion you pay on those premiums is usually not taxable income.
Home sales are also a common exclusion. If you sell your main home, you can exclude up to $250,000 ($500,000 if you’re married filing jointly) of the gain from your income if you qualify.
- Two out of the past five years have been spent owning and living in the home
- Within the past two years, you have not excluded the gain from the sale of another home
Furthermore, if you earn income from a foreign country, you may be eligible for a tax break through the foreign earned income exclusion. For the 2022 and 2023 tax years, the total exclusion is $112,000 and $120,000, respectively.
Tax Credits and Tax Deductions: What’s the Difference?
In terms of tax savings, credits are more favorable than deductions. While deductions reduce your taxable income, tax credits reduce the amount of tax owed. For example, a $1,000 tax credit cuts $1,000 off your tax bill, while a $1,000 tax deduction reduces your taxable income by $1,000. For example, if you fall into a 22% tax bracket, a $1,000 deduction will reduce your tax bill by $220.
What are the advantages of tax credits over tax deductions?
If a tax credit is refundable, it can result in a better result than a tax deduction. Tax credits that are refundable can reduce a taxpayer’s liability to zero and result in a refund. Tax deductions only limit an individual’s taxable income, whereas some tax credits return a refund.
During 2022, what gifts are excluded from the annual exclusion?
Gifts will be exempt from federal gift and estate taxes in 2022 and 2023, respectively, up to $16,000 and $17,000 respectively. This means that you can give up to those amounts tax-free to as many people as you like without the need to use any of your lifetime exemptions.
Can you get a tax break if you qualify?
Individuals with lower incomes are more likely to benefit from many tax breaks. Many tax deductions and credits phase out as an individual’s income increases, meaning a person may only be able to receive a partial refund. Tax breaks will eventually be unavailable to taxpayers with “too high” incomes.
Additionally, many tax breaks are designed to encourage specific economic activities, such as favorable tax treatment for certain retirement contributions. As long as you meet the qualification requirements, you can receive these types of tax breaks.
In the end, many people want to reduce their federal tax liabilities. Tax breaks allow individuals, corporations, and nonprofit organizations to exempt certain income from taxes, to deduct certain net income, and to take advantage of certain credits to reduce their taxes. To limit your tax exposure, it’s a smart idea to pursue tax breaks.
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