On to the next one! The next tax question pertinent to those of us in our thirties, that is…
Yesterday, I wrote about Standard Deductions vs Itemized Deductions. Today I will attempt to explain Credits vs Adjustments vs Deductions in the simplest way possible.
It took me forever to understand the difference in these terms (they’re slippery). If you can grasp them, you’re miles ahead of the tax curve..so let’s start 🙂
TOTAL INCOME: So let’s say you’re single and you make $60,000 total this year in income, including every penny that goes in your pocket. That’s your total income.
ADJUSTMENT (also known as ABOVE THE LINE deductions): Now, let’s say you paid $1,500 in student loan interest this year and contributed $3000 to a traditional IRA (retirement account). No matter whether you decide to take the standard deduction or itemize your deductions (both standard deductions and itemized deductions are known as Below the Line Deductions), you can subtract your student loan interest of $1500 and the traditional IRA contributions of $3000 from your total income! This is because they are adjustments. And adjustments are great! So your Adjusted Gross Income would be $55,500. ($60,000 – $1,500 – $3000 = $55,500).
To clarify more regarding adjustments, let’s say you still made $60,000 in total income, and you still paid $1,500 in student loan interest this year and contributed $3000 to a traditional IRA. But you also gave $500 to charity and paid $1000 in medical expenses. If you took the standard deduction on your taxes ($6,300 this year for single filers), you would still able to subtract the adjustments (student loan interest and health insurance contributions) from your total income but couldn’t subtract the $500 given to charity and the $1000 in medical expenses because they count as itemized deductions. If you itemized your deductions, you could subtract the student loan interest, retirement account money paid, AND charity donations AND medical expenses. This doesn’t mean that you should itemize though- only itemize if your itemized deductions exceed $6,300 (the standard deduction) this year!
CREDIT: So far, we’ve only talked about subtracting from your total income. How about subtracting from your tax bill? Sound good?
So lets say you have to pay $6000 in taxes. If you have a credit, it will reduce that bill dollar for dollar. So if you have a $2,000 credit, your tax bill will be $4,000 (6,000-2000). Credits are the best to have but also the hardest to come by. Credits you could possibly take include the Credit for Child and Dependent Care expenses, the Child Credit, and education credits (like the Lifetime Learning Credit and the Hope Credit).
Let’s illustrate all of this below:
Total income (sum of all your income)
— Above the line deductions
= Adjusted gross income ← “The Line”
— Standard deduction or itemized deductions
— Exemptions (you can always take an exemption for yourself, and then more for your dependents. Right now the exemption per person is $3,950.)
= Taxable income
Here’s our example plugged in:
$60,000 Total Income
— $4,500 Above the line deductions (adjustments)
= $54,500 Adjusted Gross Income ← “the line”
— $3,950 Exemption
— $6,200 Standard deduction
= $44,350 Taxable Income
Hope this helps! Let me know if you have any questions or comments! 🙂