Tax Benefit: Definition, Types, IRS Rules

What Is a Tax Benefit?

The term tax benefit refers to any tax law that helps you reduce your tax liability. Benefits range from deductions and tax credits to exclusions and exemptions. They cover various areas, including programs for families, education, employees, and natural disasters.

Some tax benefits are related to the ability to pay taxes. For example, the child tax credit and the earned income tax credit (EITC) recognize the cost of raising a family. Other tax benefits, including mortgage interest and charitable donation deductions, are incentives designed to further social policy goals.

Key Takeaways

  • Tax benefits create savings for individual and business taxpayers.
  • Common tax benefits include deductions, credits, exclusions, and shelters.
  • You can take standard or itemized deductions plus any available above-the-line deductions.
  • To qualify for tax benefits, you must meet specific requirements, such as income limits, filing status, and dependent status.
  • Be sure to stay abreast of any tax benefits you may be eligible for so you don't miss out on tax savings.

Understanding Tax Benefits

Tax benefits help individuals and corporations reduce their overall tax bills. These benefits are a significant part of the tax regulations and legislation set by local, state, and federal governments.

Tax benefits like deductions, credits, exemptions, and exclusions reduce the amount you owe annually to federal and state governments. On the other hand, tax shelters help lower taxes through particular investments. These are legal vehicles that provide favorable tax treatment. Common examples of tax shelters include municipal bonds and employer-sponsored 401(k) plans.

You must be eligible for tax benefits to claim them. For instance, to qualify for head of household status, you must be unmarried, have a qualifying dependent who lives with you, and pay more than half of the household expenses for the year. And tax benefits for educational expenses can only be claimed by those who spend money on tuition and other related costs during the tax year.

It makes financial sense to learn about any tax benefits you might be eligible for. Without the proper knowledge, you could end up paying more in taxes than you owe. It can be helpful to consult a tax professional, such as an accountant, to maximize your tax savings.

Types of Tax Benefits

As noted above, tax benefits come in all shapes and sizes. We've highlighted some of the more common ones below.

Tax Deductions

A tax deduction reduces your taxable income. When you file your annual income tax return, you have the option to take the standard deduction or itemize your deductions:

  • Standard Deduction: The standard deduction is a fixed dollar amount that reduces taxable income. For 2022, the standard deduction is $12,950 for single filers and married taxpayers filing separately, $19,400 for heads of household, and $25,900 for married couples filing jointly and surviving spouses. For 2023, these figures increase to $13,850, $20,800, and $27,700, respectively.
  • Itemized Deductions: Itemized deductions are qualified expenses allowed by the Internal Revenue Service (IRS) to decrease your taxable income by listing them on Schedule A of your tax return. The sum of your itemized deductions reduces your adjusted gross income (AGI). There is no limit on itemized deductions for tax years between 2018 to 2023 due to the Tax Cuts and Jobs Act.

Itemizing your deductions makes sense if the sum of your qualified expenses is greater than your standard deduction. For example, if a single taxpayer's itemized expenses total $13,000, they would likely itemize rather than take the $12,550 standard deduction. However, if the same filer's qualified expenses total just $8,000, they would save money by taking the standard deduction.

Even if you don't itemize, you can take certain above-the-line deductions with the standard deduction. These include student loan interest, traditional individual retirement account (IRA) contributions, contributions to health savings accounts, and more. All these deductions lower taxes by reducing taxable income and possibly lowering your tax bracket.

Say, for example, a single filer has $42,000 of taxable income for the 2022 tax year, landing them in the 22% marginal tax bracket. Therefore, they pay 22% on any income over $40,525 (the beginning of the 22% tax bracket). However, if they qualify for $2,000 in above-the-line tax deductions, they will be taxed on $42,000 - $2,000 = $40,000, giving them a marginal tax rate of 12%.

Tax deductions often reduce the total amount of income earned for businesses. Most companies use a standard income statement to calculate their taxable obligations, with taxation falling on the last line.

Tax Credits

Tax credits also save you money, but they work differently than deductions. A tax credit is applied to the amount of tax you owe after all tax calculations are made. For example, if you owe $3,000 after taking deductions and calculating taxes with your marginal tax rate, a $1,000 credit would reduce your tax bill to $2,000.

There are many types of tax credits available for individuals and businesses. For individuals, some of the most common tax credits include the child tax credit, the EITC, and the premium tax credit.

Tax credits are either refundable or non-refundable. A refundable tax credit results in a refund check if the tax credit exceeds your tax bill. For example, say you apply a $3,400 tax credit to your $3,000 tax bill. Your bill would be reduced to zero, and you would receive the remaining portion of the credit as a refund. In this case, it would be $400.

non-refundable tax credit does not result in a refund because it only reduces the tax owed to zero. Using the example above, if the $3,400 tax credit were non-refundable, you would owe nothing to the government but would forfeit the $400 that remains after the credit is applied. Some examples of non-refundable tax credits include the saver’s credit, adoption credit, child care credit, and mortgage interest tax credits.

Tax credits do not impact your taxable income or marginal tax bracket. They are subtracted from your tax bill to directly reduce the amount of tax you owe.

Exemptions and Exclusions

The Tax Cuts and Jobs Act (TCJA) suspended the personal tax exemption for 2018 through 2025, but some tax exclusions still apply. Tax exclusions usually arise in pretax payments that help you lower your taxable bottom line. Income excluded for tax purposes usually does not show up on your tax return at all.

One of the most common exclusions is the employer-based health insurance payment program. If an employer takes healthcare payments on a pretax basis, an employee’s taxable income is lowered at the end of the pay period, which reduces the amount of tax owed.

The annual gift tax exclusion is $16,000 for 2022 and increases to $17,000 for 2023. You can gift up to that amount tax-free to as many people as you wish without using up any of your lifetime gift and estate tax exemption.

Tax Shelters

A tax shelter provides a variety of tax advantages. It is generally a vehicle with lower or no tax requirements if you abide by the contracted terms. One of the most popular tax shelters is the 401(k). That's because investors are sheltered from paying a higher tax rate during their higher-earning years than they are likely to pay in retirement when their income (and tax rate) is lower.

Tax havens can also be a type of tax shelter. These are often used by businesses. Companies may incorporate in certain regions to lower their business tax bill. Some of the most popular tax havens include Bermuda, the Bahamas, and the Cayman Islands.

Not all tax shelters are legal and legitimate. The IRS treats illegal tax shelters as fraudulent activities. Taxpayers who use illegal tax schemes may face penalties, criminal prosecution, and prison time.

Certain investment products may offer a tax shelter or tax exemption in and of themselves. Municipal bonds, for example, are exempt from federal and state taxes if aligned with the state in which the bondholder lives. Other tax-advantaged investments include tax-free savings accounts, municipal mutual funds or exchange-traded funds (ETFs), and some life insurance policies.

What Is the Difference Between a Tax Credit and a Tax Deduction?

Tax credits and tax deductions both reduce the amount of tax you owe, but they work in different ways. Tax credits directly lower the amount of tax you owe, while tax deductions decrease your taxable income.

Say you're eligible for a $1,000 tax credit and a $1,000 tax deduction. The tax credit reduces your tax bill by that same $1,000. So, if you owed $1,500 in taxes and then took a $1,000 credit, your tax bill would be $500 ($1,500 - $1,000). On the other hand, the tax deduction reduces your taxable income by $1,000. So, if you fall into the 22% tax bracket, the $1,000 deduction would save you $220 ($1,000 × 22%). Tax credits are more favorable because they save you more money than tax deductions.

What Is the Estate Tax Exemption for 2022?

The estate tax is the amount below which a decedent's estate is not subject to taxes. For 2022, the exemption is $12.06 million. For 2023, it increases to $12.920 million.

How Much Is the Earned Income Tax Credit for 2022?

The earned income tax credit is a refundable tax credit for low- and moderate-income households. If you're eligible for the EITC, the amount you receive depends on your filing status, income, and the number of dependents you can claim. For 2022, the maximum earned income tax credit is $560 if you have no dependents, $3,733 for one dependent, $6,164 for two dependents, and $6,935 for three or more dependents. These amounts increase to $600, $3,995, $6,604, and $7,430, respectively, for 2023.

The Bottom Line

It's important to know where you stand with respect to your tax bill even if it isn't tax season. Keeping on top of the tax benefits that apply to you can spell the difference between a refund and a huge tax bill—or at least breaking even when it comes time to file. These benefits range from tax credits and deductions to exclusions and exemptions. Be sure to speak to a tax professional if you're unsure about how they may work for you.

Article Sources
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