Even though my yard is the greenest and most lush it has been for three months, I know that year is winding down. The trees are bare and the nights have a distinct chill to them. Christmas music is already playing on a local radio station (yes, really - since early November). Thanksgiving decorations are visible throughout the neighborhood. My wife has already mentioned finding time to untangle all the Christmas lights and get them outside before the first hard freeze.
Along with these end of year characteristics coworkers start talking about the money they have to spend on tax deductions.
Deduction vs. Credit
The end of the calendar year is also the end of the tax year for almost all of us. That means we start thinking about our tax burden that will be due by April 15. As we finalize our plans, it is important that we first know the difference between a tax deduction and a tax credit. Both terms are in the tax code, and both items reduce your tax burden, but they are not the same thing.
A tax deduction is a cost or expense on which the government has decided it will not tax you. For example, when you donate $500 to your church, the government does not tax you on that $500 that you just spent. A tax credit, however, is actually applied to your tax burden. For example, if you qualified for the new homeowner tax credit, you can apply up to $8000 against your taxes; the government considers a portion of the money you spent as your tax payment.
Tax credits are further defined by whether or not they are refundable. Refundable credits mean that you can actually get cash back at tax time if you paid taxes and had credits above your tax liability; non-refundable tax credits can only reduce your liability to zero.
Deductions Are Not Free
As you can see, there is a difference in a deduction and a credit. To put it in practical terms, take a hypothetical example. Say you make $40,000 and your tax rate is 15%, or $6000. Now, take a $10,000 tax deduction for money spent on your mortgage; you have to pay 15% tax on $30,000, or $4500. You take home $25,500.
If you spend $10,000 on home improvements to get a 25% tax credit, you still owe 15% of $40,000, or $6000. However, you get a $2500 credit to your taxes, so you only pay $3500 in taxes. Your take home is $26,500, or $1000 more; plus you have the improvements to your home.
So either way you are spending money. Usually, though, tax credits are for items you would buy anyway: a new furnace, a new dryer, a new car. Tax deductions are usually for money you have given to someone else for little or nothing in return, such as a donation or interest on your home.
The catch comes when you deduct work expenses. Yes, you know exactly what I mean. Your union dues, your uniform expenses, that new patrol rifle you want to buy; anything you can tie to your work you want to deduct. The only problem is the federal government expects you to spend part of your income on work anyway; 2% of your AGI (adjusted gross income) to be exact. So, keeping with the $40,000 income, the first $800 you spend is not deductible. Everything after that is. So, if you spend $2000 on a new rifle, magazines, body armor and the like, you can only deduct $1200 from your income. At a 15% tax rate, it saves just $180 from your taxes.
There is the catch. You are so wrapped up in getting deductions to reduce your tax burden, you just spent $2000 hoping to avoid $180 in taxes. That's kind of like the giving someone 4 quarters every time they give you 9 dimes and hoping to make it hope on volume. Even those of you who hate math can see it just doesn't add up.
Now, with all of that said, I don't want you to stop paying your mortgage, donating to church or buying equipment you need for work. By all means, spend your money wisely and ethically. I also suggest you take every legal tax loophole Congress wants to throw your way. What you should not do is go on a buying rampage at the end of the year hoping to reduce your tax burden. Even if taxes go up and you are in a 25% or 35% tax bracket, the math still doesn't hold up. At 35%, you still have to spend $1000 to save just $350 in taxes.
We all hate paying taxes, especially more than we have to. Unfortunately, they are a necessary evil; heck, they are a necessary evil that pays most of our salaries. However, over-spending to reduce your tax burden ends up costing you more. Plan your purchases, buy what you need, and take the deductions that come. Just be smart about it. Oh, and let me know if you can help me untangle the Christmas lights; new ones are not tax deductible.