Tax Benefits, Types, and IRS Rules Explained

Tax Benefits, Types, and IRS Rules Explained

Every permanent citizen and resident, including resident aliens and business owners in the US, is obliged to fulfill their tax obligations. In reality, taxes take up a significant chunk of one’s regular expenses, which is why it is only natural to try and maximize any tax benefit to balance their budget and expenditures.

But how do you know whether you qualify for one or more tax benefits? This article will help you become familiar with the different types of tax benefits available, including the IRS rules that govern them.

Without further ado, let’s get started!

Key Takeaways

  • Tax benefits are either tax credits, tax deductions, tax shelters, or exemptions and exclusions.
  • Each type of tax benefit has a specific set of requirements. It is important to know one’s filing status and tax bracket to know which tax breaks apply to their regular salary.
  • Tax credits can potentially refund any amount of taxpayers’ money used to pay taxes in excess. Tax deductions only diminish taxable income.
  • The TCJA suspended personal tax exemptions from 2018 to 2025 but increased standard deductions and child tax credits.

What is a Tax Benefit?

A tax benefit or tax break is any set of federal, state, or local regulations designed to diminish one’s tax obligations. Tax benefits take on several different forms, including tax credits, tax deductions, tax exemptions, and tax shelters.

Tax credits, exemptions, and deductions all effectively decrease the annual state and federal taxes owed by taxpayers. Tax shelters, on the other hand, entail specific investments, such as employer-sponsored 401(k) plans, to reduce taxes.

Breaks on tax liabilities may also be in the form of programs that provide assistance to families, employees, and victims of natural disasters.

Note that each type of tax break comes with its own set of qualifications and requirements. Some key factors to consider include the taxpayer’s filing status, tax bracket, and capacity to fulfill their taxes.

Why are Tax Benefits Important?

Creating more leeway for taxpayers to save more disposable income for their basic needs and savings is one of the biggest benefits of qualifying for a tax benefit. This is especially true for those who belong to the lower income bracket and only make enough to survive the day.

Another important aspect of a tax break is that it balances the amount that the government levies on taxpayers with any relevant expenses that the latter has to fulfill. For instance, if a parent pays for their child’s tuition fees, it would be quite burdensome on their part to cover the same amount of taxes that a single taxpayer owes without any dependents.

Similarly, small business owners and self-employed individuals are simply not financially cut out to match the tax amounts levied on big corporations.

Indeed, taxes are meant to fund programs for the well-being of the people, but they should not be paid to the extent that tax obligations comprise almost 90% of every taxpayer’s hard-earned income.

Different Types of Tax Benefits

Now, let’s discuss the most common types of tax benefits:

#1. Tax Deductions

Tax deductions have two variations: the standard deduction and the itemized deduction.

Standard deductions refer to flat dollars that minimize an individual’s taxable wages and vary per tax year. The tax deductions for the 2023 tax year are as follows:

  • Single. $13,850
  • Head of Household. $20,800
  • Married Filing Separately. $13,850
  • Married Filing Jointly. $27,700
  • Surviving Spouses. $27,700

Common examples of tax deductions include educational costs, mortgage interest deductions, retirement contributions, and charitable donations.

Itemized deductions are classifications the Internal Revenue Service (IRS) has approved as qualifying expenses. This type of tax deduction is only applicable if the total of combined qualified expenses exceeds a taxpayer’s standard deductions.

The sum of itemized deductions significantly minimizes a taxpayer’s adjusted gross income (AGI).

#2. Tax Credits

Tax credits are implemented on the remaining tax amount that an individual earns after all tax calculations and deductions are applied. The IRS uses a taxpayer’s earned income, family size, savings, investments, and income level to assess whether a taxpayer qualifies for tax credits.

Examples of tax credits include the child tax credit, the lifetime learning credit, and the premium tax credit.

A tax credit may be refundable or non-refundable.

Refundable Tax Credits

Refundable tax credits are eligible for a refund if the credit outweighs the taxes owed. The excess amount is then refunded to the taxpayer.

Redeemable tax credits discount individual liabilities.

Examples of refundable tax credits:

  • Additional child tax credit
  • Earned income credit
  • Self-employment tax
  • Taxes levied on premature retirement account distributions

Non-Refundable Tax Credits

Non-refundable tax credits do not yield any redeemable amount but are meant to lessen taxes owed. It is possible for a taxpayer’s non-refundable tax credits to reduce their taxes to zero.

Non-refundable tax credits include:

  • Adoption credit
  • Foreign tax credit
  • Residential energy credit
  • Saver’s credit.

#3. Exemptions and Exclusions

Tax exemptions cancel an individual’s or organization’s federal, state, and/or local tax liabilities. Generally, nonprofit organizations, low-income taxpayers, and taxpayers with several dependents are tax-exempt.

Other examples of tax exemptions are government entities, pension schemes, and tax-free goods.

However, the Tax Jobs and Cuts Act (TCJA) temporarily removed personal exemptions. The suspension of tax exemptions is said to run from the tax year 2018 to 2025.

As a countermeasure, the TCJA increased child credit and standard deductions and retained exclusions.

Exclusions refer to earnings that are not included in an employee’s gross income. Typical exclusions include federal subsidies or grants, employer-covered health reimbursement arrangement contributions, and retirement earnings.

Foreign-earned income is also considered an exclusion. The condition is that if a taxpayer earns income abroad, they must stay within the foreign country where the income is made for the majority of the tax year.

Take note that exclusions are not subject to tax limitations or reductions.

#4. Tax Shelters

Tax shelters are more typical for taxpayers belonging to a higher tax bracket and corporations. A tax shelter is a legal process for decreasing one’s tax liabilities.

It may be in the form of overseas bank accounts, investment accounts, or transactions that create credits and deductions to limit taxable income.

Other forms of tax shelters are 401(k) contributions and municipal bonds. Municipal bonds are issued by either the state or local government, and they serve as debt or fixed-income security. It is usually given whenever there are infrastructures, schools, and roadwork to be built.

Difference Between Tax Credits and Tax Deductions

In a nutshell, a tax deduction is any amount subtracted from a taxpayer’s taxable earnings. A tax credit is a dollar-for-dollar reduction of one’s tax payables.

Most taxpayers prefer tax credits over tax deductions because the former enables them to get a portion of their money back. At the same time, tax credits directly decrease the taxes that they have to pay to the government.

On the other hand, tax deductions are highly dependent on the taxpayer’s tax bracket. For example, if a taxpayer belongs to the lower tax bracket, the amount reduced from their taxable income may not be as much compared to those in the higher categories.

Let’s say you owe $5,000 on taxes, but you are qualified for a $2,000 tax credit. That means you deduct the $2,000 tax credit from the original amount of taxes you owe, which is $5,000, thereby leaving you with only $3,000 worth of taxes to pay.

However, if you were to apply a 10% deduction to your taxes, it would only yield a $500 decrease.

Popular Tax Credits, Deductions, and Benefits for 2023

The following are some of the most popular types of tax credits, deductions, and benefits for the tax year 2023:

#1. Child Tax Credit (CTC)

This is a type of compensation designed to provide assistance to parents in managing the expenses that come with raising and providing for their child’s basic needs.

#2. Child and Dependent Care Credit

It is designed to help parents and spouses hire childcare services to help look after their eligible or disabled child or dependents while they focus on job hunting or fulfilling their work.

#3. Earned Income Tax Credit (EITC)

The EITC helps reduce the taxable income of families earning low-to-moderate wages. The amount of credit a qualifying taxpayer may be entitled to also depends on their marital status and the number of dependents they have.

#4. Energy Efficient Home Improvement Credit

Homeowners and even self-employed individuals who spend money on making their homes moreenergy efficient are qualified to use this type of tax credit.

#5. Gambling Loss Deduction

Individuals who bet in casinos, lotteries, and horse races can deduct losses they incur from gambling. Gambling losses must not exceed gambling income and are itemized on Schedule A of Form 1040.

#6. Home Office Deduction

A home office deduction is typically applicable to self-employed professionals, freelancers, and independent contractors.

#7. Lifetime Learning Credit

A lifetime learning credit enables students to claim up to 20% of the initial $10,000 they used to pay for their school fees and tuition expenses.

#8. Low-Income Housing Credit (LIHTC)

LIHTC helps low-income taxpayers and housing developers afford construction and renovation expenses.

#9. Mortgage Interest Deduction

In a mortgage interest deduction, the mortgage interest is subtracted from the taxpayer’s taxable earnings. Qualifying homeowners can apply this type of deduction to their federal income taxes.

Final Thoughts

Taxpayers have the right to maximize all possible options they have for reducing their taxable income, as long as it is within legal terms. Yes, paying taxes is one of the key obligations of every citizen to the country.

However, that should not leave workers, families, and business owners strictly confined to the fixed regulations that primarily serve the ministries governing the treasury.

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