As if Basis Tax Law weren’t confusing enough, now I’m talking tax flavors?
This chapter may seem basic, but many people still struggle with understanding the basic definitions of tax ramifications.
The four flavors of tax:
- 1. A tax deduction is not a tax credit. This is the most common misconception I hear. For instance, how many times have we heard someone dismiss how much something costs by claiming, “it doesn’t matter, it’s deductible.” Well, it does matter. A deduction can only offset a portion of the cost equal to your marginal tax bracket. So if your marginal rate is 25%, every $100 you spend in deductible items can only get you $25 back at the most. So you are still out the $75.
Marginal tax rates are only the rate of tax we will pay on any additional dollars earned. Let’s say you make $100,000 in a year and your marginal tax rate is 28%. Many people assume they are paying $28,000 in income tax. The reality is that some of you are taxed at lower rates, thanks to exemptions and itemized or standard deductions. Many taxpayers pay an average rate of 12% to 15% on their total income.
- 2. A tax credit, as opposed to a tax deduction, is a dollar-for-dollar benefit. Here, a $100 credit really is worth $100, as opposed to the $25 in the previous example for a deduction. Are all tax deductible items going to get you a tax refund at your marginal rate? The answer is “no.” Many so-called tax deductible items like tax preparation fees or medical costs have significant restrictions on their ability to offer you any true tax relief. Other deductions like passive losses or larger charitable donations may only be deductible in a future year through the use of carry forwards of these amounts.
- 3. Tax-deferred earnings will someday require the tax to be paid. For instance, earnings in your 401(k) plan are tax deferred.
- 4. Tax free is something completely different. If you sell your residence at a gain of say $100,000, this gain may be tax free, meaning nobody will ever pay tax on it.