What Is a Tax Break?
A tax break is a reduction of a taxpayer's total liability. The term is also used to refer to the favorable tax treatment of any class of persons in the United States.
If the government gives a tax break to a particular group of people or type of organization, it reduces the amount of tax they would otherwise have to pay or changes the tax system in a way that benefits them.
- A tax break is a reduction of a taxpayer's total tax liability.
- There are three types of tax breaks: a tax deduction, a tax credit, and a tax exemption.
- A tax deduction reduces the amount of gross income that is subject to taxes.
- A tax credit offsets the taxpayer's liability on a dollar-for-dollar basis.
- A tax exemption shields a portion of income from taxation.
Understanding a Tax Break
A tax break can greatly reduce a taxpayer's liability. The savings may be enabled by a tax deduction, a tax credit, or a tax exemption.
Tax breaks are often explained as a means to stimulate the economy by increasing the amount taxpayers have to spend or businesses have to invest in their growth.
They also are used to promote certain types of behaviors that are seen as beneficial, such as the replacement of gas-guzzling cars with modern fuel-efficient vehicles.
Types of Tax Breaks
Tax deductions are expenses that can be subtracted from gross income to reduce taxable income.
For example, if a single filer's taxable income for the tax year is $75,000, the person will fall in the 22% marginal tax bracket for 2020 and 2021. The total marginal tax bill will be 22% x $75,000 = $16,500. However, if that person qualifies for an $8,000 tax deduction, the income taxed will be $75,000 – $8,000 = $67,000 taxable income, not $75,000. That reduces the person's tax bill to $14,740.
The reduction of taxable income is a tax break for the taxpayer who ends up paying less to the government.
A tax credit reduces a taxpayer's tax liability dollar-for-dollar. That has a greater impact than a deduction, which merely reduces the amount of income subject to taxes.
In effect, a tax credit is applied to the amount of tax owed by the taxpayer after all deductions are made from the person's taxable income. If an individual owes $3,000 to the government and is eligible for a $1,100 tax credit, the amount owed will be reduced to $1,900 after the tax break is applied.
An exemption screens a certain portion of income or type of income from taxation.
For example, an expatriate who earns income in a foreign country is eligible for a tax break of $107,600 as of the 2020 tax year. This is applied through the Foreign Earned Income Exclusion (FEIE).
An expat who earns $180,000 for a job in a foreign country, for example, will be taxed only on the amount that exceeds $107,600, or $72,400.
Charitable organizations and religious institutions are generally tax-exempt. That is, they are not required to pay federal income taxes.