What Is a Tax Benefit?

The term tax benefit refers to a tax law that helps taxpayers reduce their tax liabilities. Tax benefits are often created as a type of incentive for promoting responsible behaviors or commercial activities. These benefits range from deductions to tax credits to exclusions and exemptions. Benefits can cover a variety of areas, such as programs for families, education, employees, and natural disasters. Tax benefits are created through tax regulation, which is determined by federal, state, and local governments.

Key Takeaways

  • Tax benefits create savings for individual and business taxpayers.
  • Common tax benefits include deductions, credits, exclusions, and shelters.
  • Taxpayers may take standard or itemized deductions along with any above-the-line deductions if applicable.
  • Entities must qualify for the tax benefits they use to lower their tax bills.
  • Individual and commercial taxpayers should stay abreast of any tax benefits they may be eligible for in order to capitalize on their rightful tax savings.

Understanding Tax Benefits

As mentioned above, tax benefits come in many different forms, helping individuals and corporations reduce their overall tax bill. These benefits may come in the form of tax credits, tax deductions, and tax exemptions or exclusions. These benefits are a larger part of tax regulation or legislation that is set by the government—local, state, and federal.

Though tax deductions, credits, and exclusions are benefits that reduce the amount taxpayers owe annually to federal and state governments, tax shelters are another form of tax benefit that can help to lower taxes through special investments. These are legal vehicles that provide taxpayers with a favorable form of tax treatment. Common examples of tax shelters include municipal bonds and employer-sponsored 401(k) plans.

Taxpayers are required to qualify for tax benefits in order to claim them. For instance, married individuals must demonstrate a viable married relationship in order to qualify for spousal tax benefits. And tax benefits for educational expenses can only be claimed by those who spend money on tuition and other related expenses during the tax year.

Both individual and commercial taxpayers are wise to research and maintain awareness of any tax benefits for which they may be eligible. Without the proper knowledge, individuals and businesses may end up paying than they have in taxes. That's why it's important to consult a tax professional, such as an accountant, in order to maximize your tax savings.

Types of Tax Benefits

Tax Deductions

A tax deduction reduces a taxpayer’s taxable income. Individuals must decide on one of the following deductions to lower their liability the most:

  • Standard deduction: A fixed dollar amount that reduces taxable income. For 2021, a single taxpayer can claim a $12,550 ($12,400 for 2020) standard deduction.
  • Itemized deductions: Expenses allowed by the Internal Revenue Service (IRS) to decrease a taxpayer’s taxable income by compiling a list of qualified expenses on their tax return, the sum of which is used to lower their adjusted gross income (AGI).

Itemized deductions are well suited for those who find 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 expenses are $12,900, they will likely choose to itemize rather than apply the standard deduction to their AGI. But if the same filer’s qualified expenses total $8,000, they should opt for the standard deduction.

Many taxpayers also have above-the-line deductions they can take along with the standard deduction, even if they don't itemize. These can include student loan interest, traditional individual retirement account (IRA) contributions, tax-sheltered self-employment retirement savings, and more. All of these deductions lower the amount of taxes a taxpayer pays by reducing the amount that is eligible for taxation and possibly lowering their tax bracket.

A single filer with taxable income for the 2021 tax year or $42,000 falls in the 22% marginal tax bracket, which means they pay 22% on their income over $40,525 (the beginning of the 22% tax bracket). But if they qualify for an extra $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%.

For businesses, tax deductions often lower the total amount of income earned. Business owners and corporations have an easier time because tax deductions are much simpler to calculate. Most businesses use a standard income statement to calculate their taxable obligations, with taxation falling on the last line.

Tax Credits

A tax credit is applied to annual taxation calculations, but in a different way than deductions are. A tax credit is applied to the amount of tax owed after all tax calculations are made. For example, if an individual owes $3,000 after applying all deductions and calculating taxes with their marginal tax rate, then a $1,000 credit would reduce their 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 healthcare premium tax credit, the earned income tax credit, and the child tax credit.

Tax credits may be refundable or nonrefundable. A refundable tax credit results in a refund check if the tax credit exceeds the ending tax bill. A taxpayer who applies a $3,400 tax credit to their $3,000 tax bill will have their bill reduced to zero, and the remaining portion of the credit, that is $400, refunded to them.

A nonrefundable 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 was nonrefundable, the individual will owe nothing to the government but also forfeit the $400 that remains after the credit is applied. Some examples of nonrefundable tax credits include the Saver’s Credit, adoption credit, child care credit, and mortgage interest tax credits.

Tax credits do not have any impact on marginal tax brackets.

Exemptions and Exclusions

The 2017 Tax Cuts and Jobs Act (TCJA) removed tax exemptions but some tax exclusions still apply. Tax exclusions usually arise in the form of pretax payments that help a taxpayer lower their taxable bottom line. Income that has been excluded for tax purposes usually does not show up on a taxpayer’s 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 lowers the amount of tax owed.

Tax Shelters

A tax shelter provides taxpayers with a variety of tax advantages. It is generally a vehicle that has lower or no tax requirements if the investor agrees to the contracted terms. One of the most popular 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 is lower.

Tax havens can also be known as a type of tax shelter, often for businesses. Companies may choose to 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.

Certain types of 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 may include tax-free savings accounts, municipal mutual funds or exchange-traded funds, and some life insurance policies.