Deductions, Credits, and Form W-4
Emma just got her first paycheck from a pizza place, and her friend Jayden says, "You'll get money back in the spring!" Another friend says, "No, you'll owe the IRS." Who is right? And what is the form your boss handed you on day one that has something to do with it? By the end of this page you will know how deductions, credits, and Form W-4 work together, and you will come back to Emma's question.
Deduction or credit?
Two tools can lower your income tax bill. They sound alike, but they work at different points in the calculation.
A tax deduction lowers your taxable income, the amount the tax rate is applied to. A tax credit lowers the tax itself, after it has been calculated.
Most people use the standard deduction, a flat amount subtracted from income that depends on filing status. Some people itemize instead, adding up specific expenses (such as mortgage interest or charitable gifts) when the total is larger than the standard deduction.
Explain in one or two sentences how a tax credit differs from a tax deduction. Then say which of these reduces the tax you owe dollar for dollar: (a) a $\$500…
Explain in one or two sentences how a tax credit differs from a tax deduction. Then say which of these reduces the tax you owe dollar for dollar:
(a) a $\$500$ credit;
(b) a $\$500$ deduction.
A taxpayer owes $\$2{,}400$ in tax before any adjustments. Calculate the tax owed after a $\$500$ credit. Then calculate the tax saved by a $\$500…
A taxpayer owes $\$2{,}400$ in tax before any adjustments. Calculate the tax owed after a $\$500$ credit. Then calculate the tax saved by a $\$500$ deduction for someone in the 12% bracket. Which helps more?
Deductions are worth more in higher brackets
The U.S. income tax is progressive: higher slices of income are taxed at higher rates. So the same deduction saves more for someone in a higher bracket, because it removes income that would have been taxed at a higher rate. A credit is a fixed dollar amount, so it is worth the same to everyone who qualifies.
| Tax benefit | 12% bracket | 24% bracket |
|---|---|---|
| $\$1{,}000$ deduction | $\$120$ | $\$240$ |
| $\$1{,}000$ credit | $\$1{,}000$ | $\$1{,}000$ |
Compare these tax benefits: a $\$1{,}000$ deduction for a taxpayer in the 12% bracket; a $\$1{,}000$ deduction for a taxpayer in the 24% bracket; a $\$150…
Compare these tax benefits:
-
a
$\$1{,}000$deduction for a taxpayer in the 12% bracket; -
a
$\$1{,}000$deduction for a taxpayer in the 24% bracket; -
a
$\$150$credit for either taxpayer.
(a) Calculate the tax savings for each.
(b) Which is worth the most to each taxpayer?
(c) Explain why a deduction is worth more to people in higher brackets, but a credit is worth the same to everyone.
Refundable and non-refundable credits
Credits come in two kinds, and the difference matters when a credit is bigger than the tax you owe.
Examples: the Earned Income Tax Credit (EITC) is refundable and helps lower-income workers. The Child Tax Credit is partly refundable. Some education credits are non-refundable, and others are partly refundable.
Your refund also includes the tax already withheld from your paychecks. If withholding is more than your final tax, the IRS sends back the difference.
Refundable credits help lower-income workers most. They often owe little or no income tax, so a non-refundable credit would give them almost nothing, but a refundable one still puts money in their pocket.
Sofia owes $\$800$ in income tax. During the year, $\$900$ was withheld from her pay. She qualifies for a $\$1{,}500…
Sofia owes $\$800$ in income tax. During the year, $\$900$ was withheld from her pay. She qualifies for a $\$1{,}500$ credit.
(a) If the credit is non-refundable, what is her tax after the credit and what refund does she get?
(b) If the credit is refundable, what is her total refund?
(c) Calculate the difference, and explain what "refundable" means.
A taxpayer's income tax before credits is $\$2{,}000$. She has $\$2{,}000$ of federal income tax withheld during the year. She qualifies for two credits: Credit A,…
A taxpayer's income tax before credits is $\$2{,}000$. She has $\$2{,}000$ of federal income tax withheld during the year. She qualifies for two credits: Credit A, $\$1{,}200$ non-refundable, and Credit B, $\$1{,}500$ refundable. Apply non-refundable credits first.
(a) Calculate her tax after Credit A, then after Credit B, and her total refund.
(b) Suppose Credit B were instead non-refundable. Calculate her refund then.
(c) Calculate the difference, and compare Credit B with a $\$1{,}500$ deduction taxed at 12%.
(d) Explain why refundable credits help lower-income workers most.
Form W-4 and withholding
When you start a job, you fill out Form W-4, "Employee's Withholding Certificate." It tells your employer how much federal income tax to withhold (hold back) from each paycheck and send to the IRS. Withholding is a prepayment on your final tax bill.
| Step | What you do | Required? |
|---|---|---|
| 1 | Name, address, Social Security number, filing status | Always |
| 2 | Multiple jobs, or a working spouse | Only if it applies |
| 3 | Claim dependents (credits such as the child tax credit) | Only if it applies |
| 4 | Other adjustments (other income, deductions, extra withholding) | Optional |
| 5 | Sign and date | Always |
So a single worker with one job and no dependents completes only Steps 1 and 5. Steps 2, 3, and 4 stay blank because there is nothing to adjust.
Now, Emma's question. If her withholding is more than her final tax, she gets a refund. If it is less, she owes. So both friends could be right. It depends on her W-4 and her total income.
Mia is single, has one job, and has no dependents. She fills out her first Form W-4. (a) Which parts of the W-4 must she complete (Step 1 for personal information and…
Mia is single, has one job, and has no dependents. She fills out her first Form W-4.
(a) Which parts of the W-4 must she complete (Step 1 for personal information and filing status, Steps 2 to 4 for adjustments, Step 5 for signature)?
(b) Why can she leave Steps 2, 3, and 4 blank?
Carlos is married filing jointly and has two children under 17. On the W-4, Step 3 lets him claim $\$2{,}000…
Carlos is married filing jointly and has two children under 17. On the W-4, Step 3 lets him claim $\$2{,}000$ per qualifying child for the child tax credit (assume this amount).
(a) What amount should he write in Step 3?
(b) He is paid every two weeks (26 paychecks a year). Calculate roughly how much less tax is withheld per paycheck because of Step 3.
(c) Explain why a W-4 changes withholding but not the actual tax owed at the end of the year.
Liam is paid every two weeks (26 paychecks a year). He receives a federal refund of $\$2{,}600…
Liam is paid every two weeks (26 paychecks a year). He receives a federal refund of $\$2{,}600$ each year and sees it as a bonus.
(a) Calculate how much extra was withheld from each paycheck.
(b) Suppose he could keep that extra amount and save it in an account paying 4% per year, with an average balance of about half the year's total. Estimate the interest he gives up.
(c) Argue for and against adjusting his W-4 to reduce withholding. Include the risk of withholding too little and owing money plus possible penalties.