Tax Breaks

Types of Tax Breaks

In order to encourage certain behavior or provide special assistance, the government gives targeted relief to select groups of taxpayers. These “tax breaks” decrease the total amount of current income tax owed by individuals and organizations. Tax breaks come in five major forms: tax exemptions, tax exclusions, tax deferrals, tax credits, and tax deductions.

Exemptions

Tax exemptions reduce taxable income. They provide organizations and individuals with relief on either a complete, reduced, or partial basis. For example, charitable and religious entities which operate under IRS Code Section 501(c)(3) do not have to pay federal income tax. Also, investors are exempt from paying taxes on the interest of tax-free municipal bonds. In addition, certain veterans are eligible for property tax exemptions.

Exclusions

Tax exclusions are items on a tax return which, though reported, are not taxed. In 2021, donors could give recipients up to $15,000 in money or property each year without incurring a federal gift tax. Individuals may exclude up to $250,000 (and couples may exclude up to $500,000) in gains from the sale of their primary residence. Also, corporate stockholders can exclude from 50 percent to 65 percent of dividend income received from other domestic companies.

Deferrals

Tax deferrals enable taxpayers to postpone tax liability on present income until some future point. For example, retirement programs such as 401(k)s and IRAs allow investors to delay tax payment on fund contributions and earnings until after withdrawal.

Tax deferral benefits retirement plan investors in three ways: Because they make pre-tax fund contributions, investors decrease their current income tax liability; because interest, dividends and capital gains within the account grow tax-free, investors enjoy an increased opportunity for earnings growth; and because they generally retire in lower income brackets, investors pay less in taxes upon withdrawal.

Credits

Tax credits are dollar-for-dollar reductions in taxes due. For example, the Earned Income Tax Credit provides low-income workers with a refundable tax credit of up to $6,728. Also, the American Opportunity Tax Credit provides eligible students a tax credit of up to $2,500 for qualified education expenses. Further, other valuable credits include reductions for childcare, adoption, residential energy, and health coverage.

Deductions

The most popular type of tax break, the tax deduction enables taxpayers to reduce their gross incomes and their tax bills accordingly. There are two major categories of deductions: standard deductions and itemized deductions.

Standard Deductions

Most taxpayers claim the standard deduction, which is a dollar-amount reduction of total income taxes owed. The basic standard deduction adjusts each year for inflation and varies according to filing status. Thus, in 2021, the standard deduction was $12,550 for single filers. Meanwhile, it was $25,100 for marrieds filing jointly and $18,800 for heads of household.

Itemized Deductions

Some taxpayers benefit more from itemizing deductions. Money spent on medical care, mortgage interest, taxes, charitable contributions and casualty losses can reduce tax liability. According to the IRS, if the total amount spent on these categories exceeds the standard deduction, the taxpayer should consider itemizing.