Deductions and Credits - Fundamentally Simple

Deductions and Credits - Fundamentally Simple

Let’s be honest here. The tax code is vast and complex. It should be. It is to be expected. After all, the tax code is a tool to enforce economic policy by the government. To provide direction by offering you and me incentives to do something they want us to do. The question is, what does the government want us to do then?

The government calls it deductions and credits. The tax code is full of lines about the various types of deductions and credits right after the first line that states “Except as otherwise provided… income means all income from whatever source derived” unless… Yes, all that’s left is an overwhelming list of deductions and credits that you and I can get to exploit if we follow what the requirements say to claim a given deduction or credit.

You could say that there’s nothing more patriotic than to exploit these deductions and credits by doing what the government says. After all, 99% of the tax code is how not to pay tax. Yes, only the first line specifies how to pay tax to then follow the subsequent lines that say unless this and that. So, to arrange one’s endeavors to allow you to not pay tax is actually what the government wants. Legally of course. Through said deductions and credits.

It is simple. A deduction is the government saying we won't tax your income if you do this. Here is a quick example. If you make $100 and reinvest $60 (reinvesting in your business is deductible), the government says “we won’t tax you on the $60 because we want you to reinvest in your business.” “Hence, we will tax you for only $40 (this is considered “Taxable Income”).”

Credits come to play once your taxable income is determined. Because credits are a direct reduction of your tax liability. Let’s do an example by using the numbers from the previous example. Your taxable income is $40. We then determine your tax liability using this number by looking at the IRS tax bracket table for the applicable year. After doing this say that it’s been determined that your tax bracket is 20%. 20% of 40$ is $8. You now owe $8 to the IRS. However, if you have a child, say the tax code says that you get a tax credit of $2 per child. You happen to have one. So, your tax liability after credits is $6.

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