What is a Tax Benefit?
Tax benefit creates some type of savings for a taxpayer that provides you with an opportunity to reduce your tax bill when you satisfy certain eligibility requirements thereby reducing a taxpayer's monetary burdens. Tax regulations usually 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. 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 come in different forms and can have different names as well. 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.
Tax Deductions are the most common type of tax benefit. When you claim a tax deduction, it reduces the amount of your income that is subject to tax. The amount of the deduction you are eligible to claim is precisely the amount of the reduction to your taxable income. A tax deduction reduces the income subject to the highest tax brackets. Individual tax deductions can be claimed as either work-related deductions, itemized deductions, education deductions, healthcare deductions, and investment-related deductions. For business and self-employed, tax deductions are often expenses that lower the total amount of income a company earns.
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 instance, if an individual owes $5,000 after applying all deductions and calculating taxes with their marginal tax rate, then a $2,000 credit would reduce their tax bill to $3,000. There are two types of tax credits:
- A nonrefundable tax credit means you get a refund only up to the amount you owe.
- A refundable tax credit means you get a refund, even if it's more than what you owe.
There are many types of tax credits available for individuals and businesses. For individuals, some of the most common tax credits include income and savings credit, family and dependent credits, healthcare credits, homeowner credits, and education credits.
Exemptions and Exclusions
Tax exclusion provides the ultimate tax benefit because the income never ends up on your tax return, and if it does, it generally comes off in another section of your return. Exclusions essentially classify certain types of income as tax-free. 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. Also, the largest exclusions to taxpayers are the foreign earned income exclusion. For instance, in 2019 the law allows you to exclude up to $105,900 of income that you earn outside the United States provided you remain in a foreign country for most of the tax year. Exclusions are not subject to limitations or reductions unlike deductions meaning you must meet the eligibility or requirements to exclude the income or you don’t.
Tax shelters are usually ways individuals and corporations reduce their tax liability. Shelters range from employer-sponsored 401(k) programs to overseas bank accounts. For businesses, Tax havens can also be known as a type of tax shelter. 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.