Adjustments, Credits, and Deductions…what’s the difference and why it matters

Pop quiz: Given the choice between a $4000 deduction or a $2500 credit, which would you take?

If you don’t know the answer (and why), you might wind up making a very costly bad decision at tax time.

This post is inspired by a recent question a client asked me (details altered slightly to protect the innocent…):

I have stock I’ve held for many years that has appreciated about $100,000. I’m considering selling it because I’ve heard capital gains rates are at an all time low and may soon rise, plus I expect my own income to rise in coming years. I’ve heard the tax rate is 15%, which would be $15,000. I also may need a minor operation soon, which I’ve been told will probably also cost around $15,000. Can I just deduct the medical costs against the tax so I don’t pay any tax from selling the stock?

The first part of this question is actually very savvy. Indeed, long-term capital gains rates (the tax rate you pay on the gain from selling assets you’ve held more than a year) are the lowest they’ve been in nearly a century, and almost certainly will rise in the fairly near future. So selling now while capital gains rates are so low can be a good move in many cases. However, the actual question at the end demonstrates a very common and fundamental misunderstanding about tax credits and deductions.

This article attempts to clear up the confusion surrounding adjustments, credits, and deductions. These three words refer to similar concepts, and they all have the net effect of lowering your tax bill. However, they each lower your tax bill in slightly different way. So it can often be the case that $1 of one is worth more than $2 of another.

Tax credits are the best kind of tax reduction. A credit reduces your tax liability dollar for dollar in the amount of the credit. A popular new credit is the American Opportunity Credit. This credit reduces your tax liability dollar for dollar on up to $2,000 of qualified educational expenses. For example, if you have a $5,000 tax liability before considering education expenses, but then you include the $2,000 of qualified expenses on your return, you just reduced your tax liability to $3,000.

Most credits aren’t worth 100% of the expenses that qualify for the credit.  In fact, the American Opportunity Credit becomes a 25% credit on qualified expenses above $2,000 but less than $4,000. So if you had $3,000 in qualified expenses, you’d get a $2,250 credit — $2,000 plus $250 on the amount over $2,000 (25% of $1000 = $250).

The important thing to realize is that once you know the amount of a credit, you know that it will reduce your tax bill by that same amount.

(Most credits are limited by your total tax liability, meaning if you only have a $1000 tax liability, a credit of more than $1000 will still only reduce your bill to $0. But there are a few credits that are “refundable” and can result in negative tax liability where the IRS actually pays you money. For more info, see this bankrate.com explanation)

Deductions reduce your taxable income. While people most often ask “What can I deduct?” when looking for ways to reduce their tax bill, deductions are actually the least valuable form of tax reduction. There are two main reason for this.

First, deductions don’t reduce your tax directly, but only the amount of income that is used to calculate your tax. In other words, they only reduce your tax by a percentage of their value. And that percentage is determined by your marginal tax bracket. Most taxpayers fall into either the 10% or 15% tax brackets, meaning that’s the percent of tax they pay on each additional dollar earned. So a $1,000 deduction for a person in the 15% tax bracket is actually worth $150 in tax savings. For somebody in the 25% tax bracket, the next largest bracket, that $1,000 deduction would be worth $250.

Second, and more important, deductions offer no tax savings at all in many situations. Nearly everybody gets a “standard deduction” they can use to reduce their taxable income automatically (in 2014, this amount was $6,200 for Single filers, $12,400 if Married Filing Joint).  If your total deductions are less than the “standard” amount, you receive no benefit at all from them because you simply take the standard deduction (with a few rare and minor exceptions). Only when the total of your deductions exceeds the standard deduction do you benefit from “itemizing” your individual deductions and taking that value instead of the standard amount. For most people who don’t have a mortgage, this means they don’t benefit from these deductions–unless they have a lot of other deductions. Furthermore, many deductions are only allowed if they exceed a certain percent of your Adjusted Gross Income (AGI). For medical expenses, only expenses that exceed 7.5% of your AGI can be deducted. For work-related expenses, investment expenses, and most miscellaneous deductions, only expenses that exceed 2% of your AGI can be deducted. (Expenses in the 2% category can be added together before the 2% reduction, they don’t have to individually exceed 2% of AGI.)

As a result, many people who think they’re going to benefit from a substantial deduction receive no benefit at all, or the benefit is significantly less than they expected.

Adjustments are reductions in your Adjusted Gross Income. These are often referred to by accountants as “above the line” reductions. In this case, “the line” refers to your AGI–aka Line 37 on recent year 1040 Forms. Adjustments reduce your taxable income, much like deductions, but unlike deductions they are not subject to any limitations based on percentage of AGI. Plus you can still take the standard deduction and receive the benefit from adjustments. Because adjustments reduce your AGI, they have some additional benefits as well.

Your AGI determines a number of things. Most importantly, your AGI determines your eligibility for most tax credits and deductions. (And, paradoxically, your AGI can determine your eligibility for adjustments and income reductions–such as Social Security not being treated as taxable–even though these items affect your AGI. It sounds circular, but it’s accomplished through the use of Modified AGI which would require a separate article.) As a result, adjustments can not only reduce your taxable income, but increase other credits and deductions as well.

One relatively common example I’ve seen is reducing your AGI to benefit from the Saver’s Credit, a credit that can be worth 10%, 20%, or even 50% of any amount you contribute to qualified retirement accounts. This credit can be claimed by individuals with AGI below $26,500 and married filing joint couples with AGI below $53,000, so a fairly large number of taxpayers potentially qualify. If you’re just above one of the thresholds for this credit, a reduction in your AGI by, for example, taking an adjustment for qualified tuition and fees might result in a few hundred dollars in savings as a result of the Saver’s Credit now that your AGI is below the threshold–plus the savings from reducing your taxable income.

Adjustments are less restricted than deductions, and they can have added benefits by reducing your AGI. (In fact, in rare cases, I’ve seen adjustments result in tax savings larger than the actual amount of adjustment thanks to this domino effect.) Generally speaking, adjustments are more valuable than deductions and less valuable than credits.

Answer(s). So to answer the original pop-quiz question, which is better: $4000 deduction or $2500 credit? Because the top marginal tax rate is 35%, this means a $4000 deduction can’t be worth more than $1400 (=4000 x .35), and for most taxpayers who are in lower tax brackets, it would be worth even less. A $2500 credit, on the other hand, is worth $2500. So the choice is clear: the credit is better.

Notice I didn’t ask to compare to an adjustment, because due to the possible domino effect of reducing AGI, it’s impossible to say how much an adjustment will be worth without knowing many details about the tax return.

And regarding my client’s question about medical deductions, here are the two main considerations:

  1. Deductions reduce your taxable income, not your tax liability directly, so $15,000 in deductions won’t directly offset $15,000 in income tax. It can only reduce the income that is used to calculate that tax liability. (In other words, he was confusing deductions with credits.) And…
  2. …A $15,000 medical deduction still has to be reduced by 10% of AGI (which based on $100,000 in income from the stock sale must be at least $10,000). And if the remaining deductible expenses plus other itemized deductions don’t exceed the standard deduction, then there’s no tax benefit at all from the medical expenses.

After considering all the factors, I advised this particular client to avoid selling the stock and doing the surgery in the same year if practical, because the income recognized from the large stock sale would wipe out nearly all the benefit from the medical deduction. This turned out to be quite the opposite from his original assumption (do surgery in the same year to get big tax savings), and he was very glad he’d paid for the advice before making his decision.

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