Have you ever gotten flustered trying to talk about taxes with your accountant? Does it seem like your accountant speaks a foreign language? You are probably not alone. The terminology is confusing. I will try to help here by defining some basic terms and then explain why using the terminology is … problematic.
A little help?
These are items that are subtracted from total income to arrive at “Adjusted Gross Income” on your tax return. The defining characteristic of an adjustment is its location on the tax return – nothing else. This is where things like retirement plan contributions show up. It might be helpful before going on to lay out a tax return formula using the basic terms I will be defining:
Total Income - Adjustments = Adjusted Gross Income (AGI)
AGI - Deductions & Exemptions = Taxable Income
Tax (from Taxable Income) - Tax Credits (non-refundable) = Tax Liability
Tax Liability - Tax Payments and Refundable Tax Credits = Tax Refund or Tax Due
While most people use deductions and credits interchangeably, they are not the same. You will either claim the “Standard Deduction” allowed based on your filing status, or the total of personal “Itemized Deductions”, whichever is higher. With the new tax code very few people will be itemizing anymore due to the increased Standard Deduction. Itemized deductions include non-business expenses you deduct, like property taxes, mortgage interest, and charitable giving.
In this category I will lump “Exemptions”, because they function like deductions. Exemptions are a flat dollar amount per person in the household that is subtracted from Adjusted Gross Income, along with deductions, to arrive at taxable income. In the new tax code these are gone.
These will be listed on a Schedule C if you have self-employment income and don’t file a separate entity tax return. These are expenses related to your business income, and they reduce the business income that shows up on page 1 of your 1040 as part of total income. They are not part of your Itemized Deductions, and you don’t have to itemize to claim business deductions (that’s a common area of confusion).
These are dollar for dollar reduction in taxes from the tax based on taxable income. Things like the child tax credit and some of the education credits show up here. Tax credits can reduce tax liability down to zero, but not below.
Refundable Tax Credits:
These are called “refundable” because they can result in a refund. They are treated as if you actually made a tax payment. The Earned Income Tax Credit and Additional Child Tax Credit are common refundable credits.
Why it all Gets jUMbl3d
That would be enough to remember, but then we have to throw in the fact that the terminology isn’t perfectly consistent. For example, the “credit” for half of self-employment tax paid, the IRA contribution “Deduction”, and Student Loan Interest “Deduction” are actually all Adjustments.
Getting Practical: How to Talk Tax
I never expect my clients to speak “tax”. If they say “deduction” or “credit” I know they could mean anything. And the only time I really define one of these terms is if it’s necessary for understanding a planning issue or to answer a question a client has. I find it’s more helpful to talk about how different items functionally impact taxes.
Ultimately it is our job as tax professionals to do the translation and make sure we get the correct and complete information. But hopefully this little insight helps you realize the confusion you may feel at times is for good cause - and also that you don't need to stress about it too much if you are working with someone who knows your situation.
In your corner,