Tax Breaks – What Are They and How Do They Work?


Taxes are an unavoidable part of life as a contributing member of society. However, for as long as there have been taxes, there have also been systems in place to find ways and means to reduce them (provided you can produce the relevant documentation). Whether it’s something complex like the research and development tax credit or tax breaks for child (and dependent) care, there’s a variety of means and ways to reduce the amount you have to pay to the state.

What Are Tax Breaks And Why Do We Have Them?

Tax breaks are essentially a reduction in the amount of money that you have to pay in taxes. There are a variety of different sorts of tax breaks that include things like medical expenses, dependent care, business expenses, etc. As long as you’re able to justify them and you can produce the necessary receipts, it is possible to reduce your taxes using these avenues.

Tax breaks serve a variety of functions. Governments can use them in order to stimulate the economy by encouraging additional injections by consumers and businesses. The assumption is that if individuals and businesses have more money to spend, then they will spend or invest it which leads to a trickle down effect and results in net economic growth.

Alternatively, the government can use it to promote certain kinds of behaviour which is why one source of tax credits and deductions comes from out-of-pocket donations to charity and more recently, there have even been tax breaks given for switching to electric vehicles. The idea is that by providing businesses and individuals with incentives (through tax breaks) that they will be more likely to engage and continue to engage in such behaviours which will contribute towards the betterment of their community. 

What Kind Of Tax Breaks Am I Eligible For?

Well, truth be told, there’s no easy answer for this. Tax laws differ from state to state which means that depending on where you live, you can be eligible for different types and different amounts of tax breaks. Furthermore, whether you’re able to get the IRS to recognise cat food as a legitimate business expenditure or clarinet lessons as a medical expense really depends on how well you can justify your case and on your individual situation. 

However, while arguably any kind of tax break is a good tax break, it’s important to know some key terms:

Tax Deductions

Tax deductions work by lowering your taxable income by a certain percentage depending on your highest federal income bracket. So how does that work out in dollars and cents?

For example, let’s say that your state is awarding a $1000 dollar deduction, and you happen to fall into the 20% tax bracket, this means that you are actually eligible for $200 in savings. The $1000 is seen as 100% so 20% of that is $200.

Tax Credit

Tax credits work a little differently. For one thing you don’t have to worry about those pesky percentages since tax credits reduce your tax on a dollar-for-dollar basis. In terms of dollars it works out something like this:

If your state is awarding a $1000 dollar deduction, no matter what tax bracket you fall into, you may be eligible for up to the full $1000 to offset your payable tax. 

If the tax credit is non-refundable, this means that whether your payable tax is $200 or $1000, either way the payable tax will be reduced to $0 but any amount leftover is forfeited. However, if you are eligible for a refundable tax claim then you’ve hit the jackpot because that means that any leftover (if your payable tax is less that $1000) will be credited to you.

In sum, the main differences between tax deductibles and tax credits is the amount of money that you will be able to offset your taxes by. A tax deductible will only be able to offset the amount based on your tax bracket while a tax claim can typically help pay off larger amounts since it’s dollar-for-dollar rather than based on a percentage. 

Whether you’re running a single-person household or a booming business, it’s important to prepare yourself for tax season. By doing the necessary research beforehand and having some knowledge of what you are or aren’t eligible for can save you a pretty penny. 

If you have no idea what to do, don’t panic. There are plenty of people who make use of the services offered by professional tax preparers in order to calculate how much they can offset their final bill and also to help them prepare the necessary documents that need to be filed. After all, the world of tax laws is seemingly always changing and incredibly complex, so if needed don’t feel too bad about getting a professional to handle it rather than pulling out your hair over every misplaced receipt. 

At the end of the day, knowledge is power. That means that it helps to stay on top of any updates the government makes to tax laws and also doing a little of your own legwork to better help you understand exactly how much you have to pay to the state every year. While it may seem like a chore, financial literacy is an important skill that pays off in the long run!