Tax Credits & Deductions

Tax credits subtract directly from what you owe the IRS as you complete your tax return. They're even better than tax deductions, because they're applied dollar-for-dollar to your tax debt for the year, and some can even result in cash back. Others can be carried forward to subsequent tax years.

An itemized deduction is a tax-deductible expense that you paid in a tax year. Itemizing involves reporting your expenses for specific types of allowable deductions, adding them all together, then entering that total on your tax return. The itemized total is subtracted from your taxable income.

The tax code allows you to effectively put some of your income aside tax-free to help meet your living expenses. It offers two options for reducing your taxable income: the standard deduction and itemized deductions. You can deduct the amount of the tax year's standard deduction from your taxable income on line 12 of your 2020 Form 1040 tax return.

Certain employees can use Form 2106 to deduct "ordinary and necessary" expenses they incur as they go about their jobs. The IRS says that "ordinary" means it's a common expense in your trade or profession. "Necessary" effectively means that you could not do your job without spending this money, or at least you couldn't do it conveniently. The expense must be "helpful and appropriate."

The foreign tax credit can be claimed against any U.S. federal income tax that's owed when an American also pays income tax to a foreign government. The purpose of the credit is to reduce the impact of having the same income taxed twice, by both the United States and the foreign country where the income was earned.

Deductions are gifts from the IRS to taxpayers, and "above-the-line" deductions are one of them. All deductions subtract from your taxable income so you pay taxes on less, but these are especially beneficial—they reduce your adjusted gross income (AGI) and are available whether you itemize or take the standard deduction. Above-the-line deductions are now listed in Part II of the 2020 Schedule 1, "Additional Income and Adjustments to Income."

The unified tax credit applies to two or more different tax credits that apply to similar taxes. In the case of estate and gift taxes, the unified tax credit provides a set amount that any individual can gift during their lifetime before any of these two taxes apply.

The Tax Cuts and Jobs Act (TCJA) was signed into law by former President Donald Trump in 2017 and took effect in 2018. Under the TCJA, the standard deduction nearly doubled. In addition to the initial increase, the standard deduction increases every year to keep up with inflation. In the 2021 tax year, the standard deduction is $12,550 for single filers (and married taxpayers filing separately), $25,100 for married couples filing jointly, and $18,800 for head of household filers.

Investment interest is interest paid on a loan where the proceeds were used to purchase property you held for investment. For example, if you take out a loan to buy stocks, interest on that loan can be deducted as investment interest. Investment interest should also be deducted when high earners calculate the 3.8% Net Investment Income Tax on net investment income.