Reduce Tax Liability: How to Lower The Taxes You Pay
Reducing your tax liability can make a big difference when it comes to filing your tax return and determining what you owe the government. There are basically three ways to reduce your tax liability, with the first being to lower your adjusted gross income (AGI) through above the line tax deductions, second is itemized tax deductions, and the third to claim tax credits.
It is important to understand the difference between a tax credit and a tax deduction. A tax deduction lowers your actual taxable income, which then indirectly reduces your tax (ex: $1,000 deduction reduces taxes by $250 for those in the 25% tax bracket). A tax credit directly reduces the taxes you pay (ex: You owe $10,000 in taxes and take a $2,000 credit, you lower taxes owed by $2,000 and now owe $8,000).
Here is information on what you need to know along with some of the most common deductions and credit for the year.
Above the Line Tax Deductions
Above the line tax deductions are known as adjustments to income and are lines 23-37 on IRS form 1040 for 2010. These deductions reduce your adjusted gross income (AGI). These deductions can be taken even if you do not itemize and take the standard deduction (discussed in more detail below). These deductions are the easiest ones to take and are applicable to a larger amount of people than the itemized deductions. These deductions are also independent of the alternative minimum tax. Below are the common above the line tax deductions that can be taken:
- Stock losses up to $3,000.
- Contributions to your 401K or IRA.
- Interest paid on a student loan up to $2,500 per year.
- Any money paid out in alimony.
- Educator expenses if you are an eligible educator. You can deduct up to $250 of any unreimbursed expenses.
- Certain Medical Expenses and money used in health care spending accounts.
- You may be able to deduct moving expenses if you moved due to a change in job or change in business location.
- If you are self employed, you can deduct 50% of the self-employment tax paid through the year.
- Education expenses like tuition and books up to $4000.00 per year.
Itemized Deductions and Standard Deduction
This is the area where many people get a little confused with the deductions. You cannot itemize deductions if you take the standard deductions. There are many deductions that can be itemized, but most of the time it is not worth itemizing because it is more beneficial to just take the standard deduction. These deductions are less valuable than the above the line deductions but can still significantly reduces taxes for some people. It becomes beneficial to itemize your deductions if they are greater than the base amount of the standard deduction (which varies by income, filing status & other factors).
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In order to choose between taking the standard deduction and itemizing, it is required that the taxes are calculated both ways and you choose the greater deduction of the two. Many people do not realize how much in deductions it actually takes to make itemizing worth it. Some of the major items that can be itemized must be 2%-10% of AGI in order to be considered for the deduction and only the portion that is greater than the 2%-10% can be deducted. If itemizing deductions is applicable to you, you will certainly want to consult with your tax preparer to find out which ones you can qualify for, but here are the items that are most often deducted.
- Losses from theft and casualty. (Can deduct the amount that is greater than 10% of AGI)
- Donations you have made to charities both in cash and non cash contributions. Donations must be made to a qualified nonprofit organization, and make sure you get a receipt when you donate to verify your donation amount.
- Interest paid on your home loan. This does not include the amount you pay each month towards your principal.
- Property Taxes for any home or property you own that is not used for a business.
- State and local taxes that you have paid.
- Home office expenses if you work from home. These must all be legitimate business expenses and only a certain percentage of items like utilities can be deducted. Make sure you read the regulations carefully when claiming these deductions.
- Job hunting costs can be deducted if you meet the qualifications.
Claiming Tax Credits
Some tax credits change from year to year, while others seem to remain pretty stable. Here are some of the items you may be able to claim on your 2010 tax return to lower your tax burden.
- Homebuyer tax credit if you purchased a home during certain months in 2010.
- Energy Efficient tax credit if you purchased and installed certain energy efficient products for your home like windows, washers, dryers and more.
- Child tax credit for each child living in your home.
- Education tax credit if you qualify.
- Certain adoption costs.
Check with your tax preparer to see if these or any other tax credits apply to you. Make sure you fill out the proper forms, include the correct documentation and file them with your tax return.
Finally, to help eliminate any confusion it is important to note that tax deductions reduce your income, but tax credits are actual dollar for dollar credits against what you owe on your tax bill.
This guest post is by Manny Davis, a tax writer that provides his readers with tax tips, news, guidance and more. His website guides people through various tax problems including tax penalties, unfiled tax returns, IRS collections and more.