A tax benefit is an allowable deduction or credit on a tax return intended to reduce a taxpayer's burden while typically supporting certain types of commercial activity. A tax benefit allows some adjustment benefiting a taxpayer's tax liability.
Breaking Down Tax Benefit
Tax benefits provide an advantage to the taxpayer while typically benefiting another entity. An example of a tax benefit is an energy tax credit; taxpayers can qualify for certain tax credits for installing energy efficient systems in their homes, which benefits the environment while reducing the demand for fuel. Quite often, tax benefits may be only available for a certain time period or tax year.
Tax benefits come in the form of deductions, credits, and exclusions, each of which has a different structure and a different effect on individual income tax liabilities.
A tax deduction reduces the taxable income of a taxpayer. If a single filer’s taxable income for the tax year is $75,000 and he falls in the 25% marginal tax bracket, his total marginal tax bill will be 25% x $75,000 = $18,750. However, if he qualifies for an $8,000 tax deduction, he will be taxed on $75,000 - $8,000 = $67,000 taxable income, not $75,000.
A tax benefit in the form of a deduction can be claimed as either a standard deduction or an itemized deduction, depending on which deduction type lowers the taxpayer’s liability the most. A standard tax deduction is a fixed dollar amount that reduces taxable income, and the amount depends on the tax payer’s filing status. For 2018, a single taxpayer can claim $12,000 standard deduction, while one who is married filing jointly can claim $24,000.
Itemized deductions are expenses allowed by the Internal Revenue Service (IRS) to decrease a taxpayer’s taxable income. Itemized deductions allow an individual to list out qualified expenses on his tax return, the sum of which is used to lower his adjusted gross income (AGI). Individuals will opt for itemized deductions if the sum of qualified expenses is more than the fixed amount provided under the standard deduction. For example, if a single taxpayer’s total itemized expense is $12,900, he will likely choose to itemize rather than apply the standard deduction to his AGI. On the other hand, if the same filer’s qualified expenses total $8,000, he will most likely opt for the standard deduction of $12,000.
A credit is a tax benefit that provides more tax savings than a tax deduction as it directly reduces a taxpayer’s bill dollar to dollar, rather than just reducing the amount of income subject to taxes. In other words, a tax credit is applied to the amount of tax owed by the taxpayer after all deductions are made from his or her taxable income. If an individual owes $3,000 to the government and is eligible for a $1,100 tax credit, he will only have to pay $1,900 after the credit is applied.
A tax credit can be either refundable or non-refundable. A refundable tax credit usually results in a refund check if the tax credit is above the individual’s tax bill. A taxpayer who applies a $3,400 tax credit to his $3,000 tax bill will have his bill reduced to zero, and the remaining portion of the credit, that is $400, refunded to him. On the other hand, a non-refundable tax credit does not result in a refund to the taxpayer as it will only reduce the tax owed to zero. Following the example above, if the $3,400 tax credit was non-refundable, the individual will owe nothing to the government, but will also forfeit the amount of $400 that remains after the credit is applied.
Tax exclusions classify certain types of income as tax-free and reduce the amount that a tax filer reports as their total or gross income. Income that has been excluded for tax purposes does not show up on a taxpayer’s tax return, and if it does, will most likely come off in another section of the return. While some types of income are excluded because they are difficult to measure, other types of income are excluded to encourage taxpayers to engage in a particular activity. For instance, workers who get job-based (or "employer paid") health insurance coverage have a tax benefit given that they do not pay taxes on the value of those policies and employers can deduct the cost as a business expense.