What Is a Tax Benefit?

Tax benefit is a broadly encompassing term that refers to some type of savings for a taxpayer. Tax benefits reduce a taxpayer's monetary burdens. Tax regulations in general are determined by federal, state, and local governments. Tax benefits are often created as a type of incentive for promoting responsible behaviors or commercial activities.

Key Takeaways

  • Tax benefits create some type of savings for a taxpayer.
  • Common types of tax benefits include deductions, credits, exclusions, and shelters.
  • 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

Tax benefits can come in a wide range of forms and may be known by a variety of names. Both individual and commercial taxpayers are wise to research and maintain awareness of any tax benefits for which they may be eligible for.

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.

Types of Tax Benefits

Tax Deductions

A tax deduction reduces a taxpayer’s taxable income. For businesses, tax deductions are often expenses that lower the total amount of income a company earns. Individual tax deductions can be claimed as either a standard deduction or as itemized deductions. The decision depends on which deduction type lowers the taxpayer’s liability the most. Above the line tax deductions also exist.

A standard tax deduction is a fixed dollar amount that reduces taxable income. The amount depends on the taxpayer’s filing status. For t2021, a single taxpayer can claim a $12,550 ($12,400 for 2020) standard deduction.

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 their tax return, the sum of which is used to lower their 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 expenses are $12,900, they will likely choose to itemize rather than apply the standard deduction to their AGI. On the other hand, if the same filer’s qualified expenses total $8,000, they will most likely opt for the standard deduction.

Additionally, many taxpayers also have above-the-line deductions that can be taken along with the standard deduction, even if not itemizing. 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 the tax bracket their income falls in.

If a single filer’s taxable income for the 2021 tax year is $42,000, they would fall in the 22% marginal tax bracket. Therefore, they would pay 22% on their income over $40,525 (the beginning of the 22% tax bracket). However, if they qualify for an extra $2,000 worth of above-the-line tax deductions, they will be taxed on $42,000 - $2,000 = $40,000, which would give them a marginal tax rate of 12%.

For business owners and corporations, 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 a tax benefit that is applied to annual taxation calculations, but in a different way than deductions. A tax credit is simply applied to the amount of tax owed by a taxpayer after all tax calculations have been 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.

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

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.

Keep in mind, some tax credits may be refundable or non-refundable. 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.

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. Some examples of non-refundable tax credits include: the Saver’s Credit, adoption credit, child care credit, and mortgage interest tax credits.

Exemptions and Exclusions

The 2017 Tax Cuts and Jobs Act (TCJA) removed tax exemptions, but some tax exclusions can still apply. Tax exclusions usually arise in the form of pre-tax 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 types of exclusions is health insurance payments through an employer-based program. If an employer takes health care payments on a pre-tax basis, an employee’s taxable income is lowered at the end of the pay period, which lowers the amount of tax owed.

Tax Shelters

Many different types of tax shelters also exist as tax benefits for taxpayers. Tax shelter is also another broad term that can encompass many types of tax advantages. Generally, a tax shelter is a vehicle that has lower or no tax requirements if the investor agrees to the contracted terms. 401(k)s are one of the most popular tax shelters 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.

Moreover, 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 taxes, 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.