In an old Seinfeld clip from about 20 years ago, Jerry and Kramer famously and comically discuss the concept of a write-off. Kramer indicates that “all these big companies, they write off everything” before they each conclude that they don’t know what a write-off is. Comedy aside, Kramer and Jerry are not the only ones who have trouble grasping the concept of a write-off.
In fact, write-off is not technically a tax term anyway. There are two types of tax benefits, a deduction and a credit. It’s often that a taxpayer will say to us, “I get a credit for that, right?” or “can I deduct that on my taxes?” Both a deduction and a credit are commonly confused for one another, and either may be called a “write-off” in the vernacular, but it’s a differentiation worth discussing.
A tax deduction is something that reduces taxable income. A credit is something that reduces tax. A further distinction of credits is whether or not the credit is refundable or not, which is a topic for a future post.
As an example, if a taxpayer has income of $100,000 and is unmarried, he or she is in the 28% bracket and, based on 2015 rates, would have paid $21,071 in tax. A $10,000 deduction would bring the income down to $90,000 and into the 25% bracket and $18,294 of tax liability. If, instead of a $10,000 deduction, there was a 10% credit, the taxpayer would still be in the 28% bracket and have a calculated tax of $21,071, but would have a $10,000 credit against it, bringing the ending tax liability to $11,071. Clearly, a tax credit is better than a tax deduction; however, deductions are more common than credits.
Most taxpayers, unless they are phased out by income levels, receive the standard deduction, or itemized deductions, if their mortgage interest, real estate taxes, state and local taxes and charitable giving (among other things) exceeds the amount of the standard deduction. The standard or itemized deductions, as applicable, reduce taxable income.
There are also deductions for exemptions. Each taxpayer is an exemption, along with dependents. In 2015, each exemption was a $4,000 deduction, unless income levels caused this deduction to be limited or phased out completely.
Other common deductions are business expenses, health savings account contributions, certain retirement plan contributions, student loan interest, and in the case of manufacturers and construction firms, the domestic production deduction.
There are credits for tax paid to foreign countries or other states, energy improvements, dependent care expenses, and others. The child tax credit is a common credit that taxpayers with children under 17 and reduces tax by $1,000 per child for married couples with adjusted gross income (AGI) under $110,000 or single taxpayers with less than $75,000 of AGI. Higher-education costs can be a credit or a deduction depending on the situation (the credit is only for a percentage of college costs, though). The earned income credit is another credit that you may hear discussed occasionally. The EIC is for low-income working families with children.
One of the most beneficial Pennyslvania credits is the Educational Improvement Tax Credit (EITC), which firm principal Jeremy Allen wrote about in 2014 for the Central Penn Business Journal.
Anything that reduces a taxpayer’s ending liability is generally good news, but knowledge about how deductions and credits differ will allow you to understand why your burden was alleviated to the extent it was when it is time to file your returns.
By Dan Massey, CPA, Manager