Before any further discussion of taxes, it’s important to note that nearly every year the IRS changes something in the tax code. Any information we provide here is based on the information available for the 2020 tax year. It’s always best to check the IRS website or consult with a tax professional, especially when considering an investment that could have an impact on your tax liability.
Most people find all of the tax rules and terminology confusing. They only know that they want to take advantage of every opportunity to lower the amount they have to pay. There are two ways to lower tax liability: Tax credits and tax deductions.
Tax credits are incentives that allow a taxpayer to subtract the amount of the credit directly from the tax that they owe. For example, the IRS offers a tax credit for some energy-saving things like solar panels. For panels installed in 2019, homeowners could get a credit for 30% of the cost (in 2020, it goes down to 26%). If the panels cost $12,000, their total tax payment in 2019 could be reduced by $3,600.
Tax deductions are a bit different. Instead of lowering the final tax bill, they are subtracted from the taxpayer’s gross income. This lowers the amount of adjusted gross income, which is multiplied by the tax rate to come up with the tax liability. The lower the adjusted gross income, the less the person has to pay.
Standard vs. itemized deductions. Taxpayers have a choice each year of taking a standard deduction (an amount set by the IRS) or an itemized deduction (adding up all of their individual deductions) on their individual tax return. Whichever amount is greater will give them the best tax benefit. For 2020, the standard deduction is $12,400 for individuals and $24,800 for married couples filing jointly. If all of the deductions we discuss in this article, plus some others, such as medical expenses and charitable donations add up to more than that, it pays to itemize. It’s usually a good idea to calculate itemized deductions to ensure the lowest tax liability.