Understanding The Terminologies Deduction, Credit, and Write-Off
There are 3 commonly used phrases when it comes to reducing taxes owed to the IRS.
In this post, I want to nerd out a bit on these 3 and talk about how they are used incorrectly, often by the layperson, what they actually mean and hopefully, in the process, I’ll be learning a little as well – pretty much the main reason I write these posts.
A Quick Summary Of The Differences
For those of you who have a life and don’t want to read my 3,000-word posts, let me do a quick recap here and if you are caught in a blizzard or hiding in the toilet from your partner, you can read all the boring little details.
This term is used in a phrase like “You can write that off on your taxes.” For the most part, this is actually just another word for a deduction. It’s an expense that is subtracted from gross earnings in order to reduce the amount of money that you must do tax calculations on.
You can write-off a contribution to your 401k against your income. Which means that you reduce your income of $100k by $18k if you max out your 401k and end up only having to pay taxes on $82k.
You do not get a dollar-for-dollar reduction in a write-off, despite what the term insinuates. If you are in the 33% tax bracket and a $2k expense qualifies to for a write-off/deduction, you will save a dollar value of $660. The other $1,340 is money you spent and that’s gone.
Deductions repay a percentage of the expense you incurred. “You can deduct that on your taxes.” This is interchangeably used with the above term write-off. However, the only main difference is that some deductions such as the Standard Deduction allowed by the IRS aren’t really a write-off because it wasn’t an expense you incurred. Otherwise, the terms are synonymous.
So, write-off = deduction. Using an example, if you spent $1,000 on something and deducted it on your taxes, you will only recover a small percentage, equal to your tax rate. If you’re taxed at 25%, then you will recover $250 from that $1k you spent by paying $250 less towards taxes.
“You can claim a credit for that on your taxes.” A credit, essentially, achieves the same thing as a write-off or deduction but in nerdeality, it is a sum of money that’s deducted after you have determined how much taxes you owe.
A credit is a dollar-for-dollar reduction of taxes owed to the IRS.
There are very few actual credits in the US tax code, and for doctors, it’s rare to qualify for these since many credits have “exemptions” and “income cut-offs”. A $1,000 tax credit means that you can deduct $1,000 from however much you owe on taxes.
Brief Overview Of How The Tax System Works In The US
Whether you earn your income from a job or from a business, you will be taxed on it by the IRS. As a matter of fact, even if you won the money or someone gifted you a large sum, you must pay taxes on it.
There are certain expenses which can be a write-off on your taxes, or in other words, they are potential deductions. Usually, it’s a percentage of the actual expense that can be deducted from your income, thereby reducing your income.
The less income you end up with after the deductions, the less money you will be taxed on.
This is how your AGI (adjusted gross income) is calculated. It’s your income, minus any adjustments (deductions). And of course again here we are using write-offs and deductions interchangeable and will do so for the rest of this post.
Here is a verbal flowsheet:
+Take your gross/total income
-Subtract “above the line” deductions
+You get your AGI
-Subtract your itemized (below the line) deductions
-Subtract your personal exemptions
+You get your actual taxable income
-Subtract tax credits from taxable income
Your taxable income is the income which will be subjected to the US income tax system.
Above-the-line and below-the-line are terms used to refer to where on form 1040 you enter a specific value. Certain expenses qualify to be deducted directly from your gross income and are therefore called above-the-line-deductions.
Your W2 Can Be Confusing
You might be asking yourself, then why the shit are taxes already deducted before I get my paycheck if I need to factor in my deductions?
In order for the country to run, it needs money. This money comes mainly from tax-payers. The gov’t can’t wait until April to run its day-to-day operations. Why? Because our gov’t is broke. It lives paycheck-to-paycheck, just like many American households out there.
On a side note, this is exactly why you should budget. Budgeting is the antidote to living paycheck to paycheck. It allows you to anticipate future expenses and plan for it.
So yes, the money is deducted from your paycheck if you get a W2 and then you have to go back, come tax-time, and factor in any deductions and credits in order to come up with your actual tax burden.
Those who are independent contractors and receive a 1099 do the same thing, they pay estimated taxes 4x per year so that the government doesn’t have to wait until tax time to get their share.
Personal Taxes Vs. Business Taxes
We’re still talking about how US taxes work. And I think I can demonstrate this really nicely by using 2 different individuals. One is a doctor who has their own practice under Dr.-Mo-Inc. and the other is employed by a medical group as Dr.-Mo.
Dr.-Mo, The Individual
Dr.-Mo earns $200k a year, gets to deduct $50k from his income in forms of a 401k and a Keogh (above the line deduction). He pays a mortgage and has contributed $3k to an HSA.
He will deduct the $50+$3k straight from that $200k, bringing the amount that he can get taxed on (taxable income) down to $147k.
His $500k home, financed at 4.5% APR, will have $22k in interest payments for that year. Because his federal tax rate (his tax-bracket) is 33%, he gets to deduct $7,260 from his gross income – bringing that $147k down to ~$140k.
He probably was also able to write-off a portion of a few expenses such medical licenses, cell phone and possibly a home office. Let’s assume that’s another $10k he was able to deduct, bringing his taxable income down from $140k to $130k.
Dr. Mo will owe Federal and State income taxes on $130k, which is his AGI.
Dr.-Mo-InC, the business
This sexy dude has his own little urgent care. He pays rent, salaries for his employees, lease payments on equipment, pays billers and has a financial adviser and a lawyer who he pays regularly for their services. He also buys medications, gloves and office supplies.
He grosses $1 million a year from the UC and spends about $500k on the above items in order to run his urgent care. This means he can directly deduct those expenses from the money the patients pay him, his gross income.
If he bought the building for the UC, he could deduct the entire mortgage payment from his UC income. If the building cost $500k, financed at 4.5%, he would deduct the whole $22k from that $1 million income.
He could also put money in a SEP IRA retirement account, to a tune of $53k for the year and deduct this from his gross income.
Looking To Reduce Your Taxes
There are very few real clever tax loopholes that doctors can use to save money on taxes. It’s a very sexy topic and the question is posed to damn near every CFP and CPA out there. “How can I save money on taxes?”
This topic deserves a brief mention here because the IRS tax code is already written, so whatever you do to try to save on taxes must be in the tax code.
The only sure way to really save on taxes is to start your own business. In which case, you also have to factor in the extra work involved in running a business and whether you can generate the kind of income you could have earned after accounting for your overhead.
If you own your own business then you can write-off damn near everything you spend in order to help you earn money. The list of qualified business expenses is massive, use your imagination and chances are that it will qualify.
As a business owner, there are some actual tax strategies that you can use in order to cleverly and legally reduce your tax burden. That’s when a tax lawyer or a business accountant might come in handy. Some CPA’s only specialize in consulting for the purpose of tax reduction.
If you are an employee, there might be a few bucks that you would be able to save if you really go digging but it’s usually not worth it. Beyond what you find in a tax software, there are few real opportunities to save on taxes.
How Much Did You Pay In Taxes Last Year?
This is a brilliant question. Do you know the answer? It’s really important that you do because it’s often the biggest expense a doctor has.
Few of us put any effort into making substantial changes to the way we generate income in order to reduce this huge liability. Rightfully so, reducing taxes here would require us to either transition from a W2 employee to a 1099 contractor or to start our own business – not always easy.
The answer shouldn’t be “I got taxes back” or “I ended up owing only $1,200”.
My federal tax burden for 2016 was $42,424. This is printed on form 1040 for my federal taxes. If you use a tax software to file your taxes, this will still show up once you print out your final forms.
Tax Credits Are Rare
Tax credits are fantastic because if you owe $100k in taxes then you get to deduct that credit directly from however much you owe to the IRS.
I just finished looking through all the tax credits that are out there which the average doctor could qualify for and there is nothing juicy to report.
And that’s the thing with credits, they are out there, but you must qualify for them. This is the reason the tax code has gotten so complicated, there is a little bit added for every different situation. The less you make, the more deductions and credits you qualify for.
Deductions Are Always Partial
Most of the tax code and the terminology used to describe it is vague, confusing, and misleading.
The only exception is the standard deduction which is something offered to damn near everyone. Once you itemize your deductions, that’s when you’re taking advantage of the various write-offs in order to decrease your taxable income.
Saying “I can deduct that on my taxes” is a bit misleading because you can only deduct a “portion” of that on your taxes.
Again, I’m just being repetitive in order to make the point. A tax credit reduces your tax burden dollar-for-dollar while a deduction reduces how much money gets taxed which is not a dollar-for-dollar reduction.