Exercises: Deductions, Credits, and Form W-4

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.

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?

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?

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.

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.

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.

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.

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.