April 15 of every year is not a day many of us look forward to. Even though we know the importance of taxes to the economy, we don’t like paying it. However, tax reliefs provide great opportunities to reduce our tax liability and feel less uncomfortable every April 15.
It still hurts to pay taxes, but since taxes and death are sure, we can quit overthinking it and start exploring opportunities to give Uncle Sam less money.
This article will provide you with all you need to know about tax reliefs and the different ways you can reduce your tax liability. You will understand the nature and importance of:
- Tax deductions,
- Tax exclusions,
- Tax credits, and
- Tax debt relief
If you want to reduce your tax liability to the barest minimum, keep reading.
Tax Deductions as Tax Reliefs
Tax deductions help to reduce your taxable income. Your taxable income includes your earned and unearned income that is subject to taxation.
Tax deductions help to reduce your taxable income, which leads to a reduction in your tax liability. They come in the form of expenses that the tax authorities exclude from taxation.
Examples of tax deductions include charitable donations, healthcare expenses, mortgage interest, property taxes, sales tax on personal properties, etc. For corporations, tax deductions include business expenses like travel, transport, and networking.
No portion of your taxable income that you spend on the above expenses (among others) is subject to taxation.
Let’s take the example of Mr. Smith, whose income is $40,000, and who spent $1,000 on charitable donations and $5,000 on property taxes.
Because charitable donations and property taxes are tax deductions, the taxable income of Mr. Smith will be $35,000 ($40,000 – $1,000 – $5,000) instead of $40,000.
Alternatively, if Mr. Smith spent the $5,000 on groceries rather than charitable donations and property taxes, his taxable income would be $40,000.
Standard and Itemized Deductions
The IRS allows every taxpayer to opt between standard and itemized deductions.
For the standard deductions, you will go with the predetermined deductions rather than outline your expenses that qualify as tax deductions.
The standard deductions are as follows:
- Single filing: $12,400
- Head of Household: $18,650
- Joint filing: $24,800
Let us continue with the example above. If Mr. Smith decided to opt-in for the standard deduction and is a single filer, his tax deductions will be $12,400. Consequently, his taxable income will be $27,600 ($40,000 – $12,400).
Alternatively, Mr. Smith can decide to itemize his expenses that qualify as tax deductions. This approach is better if Mr. Smith thinks his expenses are eligible as tax deductions are more than the standard deductions.
In the example above, where tax deductions are $5,000, Mr. Smith is better off with the standard deductions ($12,400).
Making a choice
The choice between standard and itemized deductions is simple. Opt-in for itemized deductions if your expenses that qualify for tax deductions exceed what you will get with standard deductions.
However, you need to be sure that you are not overstating your tax deductions. You may need the help of a financial planner to assure you that certain expenses truly qualify as tax deductions.
Here is a more comprehensive list of tax deductions you can itemize.
Tax Exclusions as Tax Reliefs
Tax exclusions are incomes that are exempted from taxation. For tax deductions, an income is exempt from tax because of what you do with it (expenses). However, for tax exclusions, the income is exempt from tax irrespective of how you spend it.
When an income qualifies for tax exclusion, the tax authority ignores it in calculating your taxable income and tax liability.
Examples of tax exclusions include life insurance death benefit proceeds, child support proceeds, municipal bond income, and welfare payments.
The income you contribute to retirement accounts like 401 (k) are also excluded from taxation (until withdrawal).
Some benefits from insurance, disability, injury, disaster relief payments, and federal subsidies are also excluded from tax. Income earned by military personnel while working in declared combat zones is also tax-exempt.
You can minimize your tax liabilities by understanding your income sources that qualify for tax exclusions.
Tax Credits as Tax Reliefs
Tax credits are another form of tax reliefs. Tax credits are a bit different from tax deductions and tax exclusions. While the latter (deductions and exclusions) reduce your taxable income, the former reduces your tax liability.
To put it more accurately, tax deductions and exclusions indirectly reduce your tax liability by reducing your taxable income while tax credits directly reduce your tax liability.
To see how this distinction plays out, let us continue with the example of Mr. Smith.
His total income is $40,000, his tax deductions is $5,000. Let us also assume that $5,000 of his income is from municipal bond interest and $2,000 from life insurance death benefit proceeds.
From the above, his taxable income will be $20,600 ($40,000 – $5,000 municipal bond interest – $2,000 life insurance death benefit proceeds – $12,400 standard deductions)
Suppose Mr. Smith has tax credits of $1,000, his tax liability will now be $1,274.5 ($2,274.5 – $1,000).
Tax exclusions and deductions reduce the taxable income (from $40,000 to $20,600). Tax credits reduce the tax liability (from $2,274.5 to $1,000).
Types of tax credits
There are three broad types of tax credits:
- Refundable tax credits: When your tax credit is more than your tax liability, the tax authority will refund the excess. For example, if Mr. Smith’s tax credits were $3,000, the IRS will refund $725.5 ($2,274.5 – $3,000). Earned income tax credit and premium tax credit are examples of refundable tax credits.
- Non-refundable tax credits: They are the opposite of the refundable tax credits. Non-refundable tax credits can only cancel your tax liability; you cannot get a refund if tax credits exceed tax liability. Child and development care credit, adoption, and mortgage interest credit are examples of non-refundable tax credits.
- Partially refundable tax credits: You can get refunds up to a certain amount if tax credits exceed tax liabilities. Child tax credit and American opportunity tax credit are examples of partially refundable tax credits. For the latter, you will get 40% of the remaining tax credit or $1,000.
Here is a comprehensive list of tax credits you can explore.
Tax Debt Relief as Tax Reliefs
You can also access tax reliefs through the different tax debt relief programs.
These programs aim to provide relief for individuals who cannot pay their tax debt.
Some examples of these programs are:
- Offer in Compromise
OIC allows you to settle your tax debt for a lesser amount. For example, you may settle a $10,000 tax debt for $5,000 (I am arbitrarily using these numbers for illustration). While OIC is a good relief program, the chances of approval are thin (about 25%).
Also, the application period does not add to the 10-year statute of limitations on tax debt (if you owe tax debt for up to 10 years, the IRS cannot claim it again). The number of months (years) you spend applying for OIC further extends your statute of limitations.
You can apply for OIC here.
- Currently not Collectible
If you cannot pay up your tax debt, the IRS designates your account as currently not collectible. This temporary designation speaks to your current capacity to pay rather than forgiveness of your debt.
The IRS will keep accessing your financial situation to determine when you can pay up the debt.
- Installments / Payment Plans
These are arrangements with the IRS to pay the taxes you owe within an extended timeframe. There is a short-term payment plan that allows you to pay within 120 days (plus accrued interest and penalty).
The long-term plan is a monthly installment payment agreement. The long-term option comes with extra set-up fees ranging from $31 to $225 depending on the mode of payment.
You can apply for payment plans here.
Tax reliefs are helpful ways to reduce your tax liability and keep some of your money from Uncle Sam. You can access tax reliefs through tax deductions, tax exclusions, tax credits, and tax debt relief.
The first two will reduce your tax liability, the third will reduce your tax liability, and the fourth will help you deal with tax debts.
In these four categories of tax reliefs, you will find immense opportunities to achieve tax efficiency and reduce your tax liability. If you do not know which options to explore, talk to your tax accountant.
Why pay more for tax when you can pay less? Ensure you explore these tax reliefs to the maximum.