Income tax preparation can be very confusing, not only are the laws complex, but they are ever-changing as well.
It is important that we use the correct term.
Generally, tax reducing opportunities fall into one of three categories – adjustments to income, deductions, and credits. The tax treatment and tax savings can vary significantly between these three categories. Often times a taxpayer can claim all three types of tax-saving opportunities.
An adjustment to income is taken on page one of form 1040.
An adjustment reduces taxable income, but also reduces adjusted gross income (AGI). AGI is used in several other calculations which establish the threshold for various deductions and phase out of some credits. In addition, the federal adjusted gross income is the starting point for the Ohio income tax calculation.
As a result, an adjustment to income will not only reduce the federal income tax but will also reduce the State of Ohio income tax.
Some of the most common types of adjustments to income include health insurance payments for self-employment, deductible IRA contributions, health savings account (HSA) contributions, educator expenses, alimony paid, and student loan interest. Less frequently we see moving expenses and the domestic production activities deduction, both of which are being eliminated under the new Tax Cut and Jobs Act tax laws beginning with the 2018 tax year.
Taxpayers choose between taking a standard deduction or itemizing their deductions.
Standard deductions are based on filing status for 2017 the amounts are $6,350 for single or married filing separately filing status, $9,350 for head of household filing status and $12,700 for married filing jointly filing status. There is an addition to the standard deduction if the taxpayer is over age 65 or blind.
There are 5 categories of itemized deductions. They are medical expenses, mortgage interest, state and local taxes, charitable contributions and miscellaneous deductions.
Medical expenses over 7.5% of AGI are deductible. This is one example of how an adjustment is more valuable than a deduction.
State and local taxes include real estate, income and personal property taxes.
Charitable contributions include money donated as well as the fair market value of goods donated.
The miscellaneous category includes deductions for unreimbursed business expenses, job search expenses, tax preparation fees, investment management fees, and safety deposit box fees. Deductions in the miscellaneous category over 2% of AGI are deductible.
The Tax Cut and Jobs Act affects both types of deductions beginning with tax preparation for the 2018 year.
The standard deduction amounts for 2018 will be increased to $12,000, $18,000 and $24,000. Most of the miscellaneous deductions included unreimbursed job expenses have will be eliminated. Many people believe itemized deductions have been eliminated, they haven’t been eliminated but with the increase in standard deductions more people will choose the standard deduction rather than itemizing their deductions.
An income tax credit is the third type of tax savings opportunity.
The tax credit is the most lucrative tax savings as a tax credit reduces dollar for dollar the income tax obligation, whereas adjustments and deductions simply reduce the taxable income from which the income tax obligation is computed. A tax credit can prove to be a very substantial reduction in the income tax obligation if a taxpayer meets the eligibility requirements.
Some of the most common types of income tax credits are education credits for higher education, child tax credit, credit for child and dependent care expenses, and earned income credit.
The foreign tax credit is available when a portion income has been taxed by a foreign country. Less frequently utilized income tax credits include the residential energy credit and the retirement savings credit.
The Internal Revenue Service will not know if an individual is eligible for most credits. It is up to the taxpayer to complete the necessary forms to claim the tax credit.