This is my biggest pet peeve in all of personal finance. Every single day I hear someone misuse one of these terms. Every. Single. Day. Well, it needs to come to an end so I’m gonna do my best here.
The confusion is real
As you can see in the video above, there is a fundamental misconception regarding tax write-offs, and furthermore, credits as well. You would think that people would take these things more seriously because it involves their money, but they don’t. Instead, they keep their head in the sand and repeatedly tell themselves that everything will be okay. Well, it won’t. Stop giving Uncle Sam extra money!
According to CreditKarma.com, “tax write-off” is an unofficial term for expenses that you may be able to deduct on your federal income tax return. Although you’ll often see the term used to refer to business expenses, individuals may also be able to “write off” certain deductible expenses to reduce the amount of income they have to pay tax on.
Key phrase: “reduce the amount of income they have to pay tax on.” Example: you made $130k in income. During the year, you paid $12k in interest on your mortgage for your primary home, donated $20k to charity, and had $5k in expenses for your investment property. Together, these total $37k in deductions FROM your $130k in income, so effectively, you’ll be paying taxes on $93k in income versus the entire $130k. Magically, you now owe Uncle Sam a lot less money. This is good.
Per Investopedia.com, a tax credit is an amount of money that taxpayers can subtract directly from taxes owed to their government. Unlike deductions, which reduce the amount of taxable income, tax credits reduce the actual amount of tax owed.
Example: after entering all of your deductions/write-offs you have a tax liability of $5k. BUT WAIT, you still have the child tax credit that is unaccounted for. This also tallies up to $5k. Now, the credit of $5k directly reduces the tax liability of $5k, leaving you with a $0 tax bill. Note that some credits are refundable, meaning they can be applied to your tax bill even if you owe no taxes, and some are non-refundable, meaning that they can’t. Research this prior to thinking you’ve got a credit in the bag.
Examples of misuse
Throughout my short 34 years on earth, I’ve heard deduction and write-off used in remarkably inaccurate ways. I’ll summarize below.
- I met with my “tax guy” this weekend. He said he’s going to write-off all of my lunches since they’re required as part of my job. This should help me get a bigger refund.
This is fraud. You can’t deduct this, plain and simple. It’s also not even registering on your taxes unless you exceed the standard deduction, which most people don’t. Don’t go to jail because your “tax guy” is an idiot. Also, your tax guy is a dude with a GED unless you have an actual Certified Public Accountant (CPA) preparing your taxes.
- I’m going to deduct the $90k addition I put on my house.
Yeah, that would be great, but it’s also not allowable. A couple of hours on the internet and you can learn about the actual deductions and credits that you do qualify for. Now this $90k addition does increase your cost basis in the home. This means that you’ll pay less taxes when you sell your home, especially if it exceeds the home sale exclusion amount.
- I am going to owe a bunch of taxes this year. I better go donate $30k to charity to try and lessen the blow.
Simple math shows that this won’t save money. Let’s say you’re firmly in the 22% tax bracket and you donate $30k to charity, you good samaritan you. The standard deduction is $12,500. So essentially you lowered your taxable income by the $17,500 difference. 22% taxes on $17,500 is $3,850. You essentially spent $30k to save $4k. Good work. You accomplished nothing.
How write-offs and credits can save you money
A while back, one of my coworkers was proclaiming how much he hated paying taxes and couldn’t stand the IRS. Knowing approximately how much money he makes, I replied by telling him he’s not paying taxes, but rather, the taxpayers are paying him. He didn’t understand this and couldn’t fathom it to be true. I broke out the whiteboard and broke down the following for him.
2021 Income: $65,000
401(k) Contributions: -$10,000
Health Premiums: -$5,000
Net Income: $50,000
So after having his income reduced by 401(k) contributions and health care premiums, he’s left with about $50k in taxable income. Now this is where it gets fun.
His income is further reduced by the $25,100 standard deduction for married individuals filing jointly this year. This brings taxable income down to $24,900. Keep in mind that the standard deduction always applies unless enough deductions to exceed $25,100 are available. In this case, we’ll continue with the standard deduction.
Taxes on the $24,900 will look like this:
$19,901 – $24,900: $600
Total Tax Owed: $2,590
So without any credits being applied, he owes $2,590 in tax. Not bad for having nearly $70k in income. Per the IRS, non-refundable tax credits are applied first to reduce income tax liability, so we’ll start with the savers credit. Since the individual’s Adjusted Gross Income (AGI), a figure often used to determine credit eligibility, is $50,000, he’ll qualify for a savers credit of 10% of his contribution to his 401(k) plan, which comes in at $1,000. This will directly reduce tax liability, leaving him with a bill of $1,590 at this point. For the sake of this example, we’ll say that he isn’t eligible for further non-refundable credits, so we’ll now move onto the refundable ones.
He has 3 kids, and assuming they’re all under 5 years old, they’ll each be eligible for the $3,600 child tax credit that was expanded for 2021. This totals up to $10,800. Since the child tax credit is refundable, he’ll receive $9,210 in refund after the credits are applied. Yes, you read the right, $9,210 free and clear. $9,210 in tax refund based on $65k in annual income. Considering he probably had taxes deducted via payroll all year, the refund will probably be even larger than this.
Do your research, be smarter than the system
Most people have no idea that the method above is how taxes are calculated. It’s mind-blowing that this is the case, and I hope that by writing this article I can convince just one more person to become intimately involved in their personal finances. The more you know, the better off you’ll be. Join us, become a Wealthy Idiot, today!