The Tax Credit vs. Tax Deduction Quiz

Tax season is upon us and while you don’t have to master zillions of pages of the US tax code, it does pay to know a few of the basics. Test your knowledge with the following Tax Deduction and Tax Credit quiz.

Ah, tax season. As various W-2’s and 1099s start arriving in the mail, let’s test your knowledge on simple tax basics.  Don’t worry, even if you miss every answer, you’ll still be learning an important thing or two about taxes.

Q:           Which is better, a tax credit or a tax deduction?

A:            Tax credit takes the crown on this one. Why? A tax deduction lowers your taxable income, which lowers your tax bill some amount depending on your tax rate.  On the other hand, tax credit lowers your tax bill dollar for dollar.

For example, let’s say you have an annual income of $250,000 and fall into the 33% tax bracket.

TAX DEDUCTION SCENARIO: An $18,000 401k contribution would lower your taxable income via tax deduction to $232,000 thereby reducing your current tax bill by $5940.

TAX CREDIT SCENARIO: If you were able to come up with a tax credit for $18,000, your tax bill would drop by $18,000.  This means with tax credit you’ll save an additional $12,060 ahead of the tax deduction.

Q:           What are the two types of tax credits?

A:            Refundable Tax Credit and non-refundable Tax Credit.

For example, let’s say you owe $1000 to the IRS and have a $1500 tax credit.

NON-REFUNDABLE TAX CREDIT SCENARIO: With a $1500 nonrefundable tax credit, our $1000 tax bill would be wiped clean and that is where the story ends.

REFUNDABLE TAX CREDIT SCENARIO: With a $1500 refundable tax credit, your tax bill would be wiped out AND, drum roll please, you would also get $500 back from the government.

Q:           True or false, the IRS is going to fine you big time for missing the April 15^th tax-filing deadline.

A:            It depends. Even still, please don’t procrastinate and ignore the tax deadline at your peril.

IF YOU OWE MONEY SCENARIO: The government assesses both failed to pay AND failure to file penalties The failure-to-file penalty will run you a whopping 5% of your unpaid taxes EACH MONTH which begins accruing the day after taxes are due, that is April 16th.  This can add up scary quickly as you can imagine. The failure-to-pay penalty from the IRS is much more modest but still a waste of money and stress. It comes in at 0.5% of your unpaid taxes.

IF YOU’RE DUE A REFUND SCENARIO: The non-filing penalty only applies to tax returns that owe money.  If you are due a refund, there is no huge penalty accruing for filing late. Of course, you are giving the government an interest-free loan. But be warned, don’t wait too long to file or you could lose that refund. Here’s what the IRS has to say about that on its website: There is no penalty for failure to file if you are due a refund. But, if you wait to file a return or otherwise claim a refund, you risk losing a refund altogether. An original return claiming a refund must be filed within three years of its due date for a refund to be allowed in most instances.

Q:           True or false, billionaires could have a lower tax rate than their secretaries?

A:            Oh, you knew this one was true, right? Sometimes called the Buffet Rule.

THE BILLIONAIRE SCENARIO: No surprise, the super-rich spend lots of time energy and money hiring super-smart people to keep their effective tax rates as low as possible.  And yes, often times this means they end up paying a lower effective tax rate than the average American (i.e. you and me) might shell out. Part of this may be due to how they earn their money. Billionaires are not wage slaves, clocking in and clocking out to collect a regular salary. Rather, top earners derive large portions of their income from what they own in investments (stocks, bonds, real estate)–which are generally taxed via capital gains rather as income tax–rather than what they do.  Generally, income tax rates have been higher than capital gains rates.  Plus, with proper planning capital gains are easier to defer than ordinary income.

THE WORKING STIFF SCENARIO:  For the assistants to oligarchs, on the other hand, I’m going out on a limb and assuming that most of them will be taking home a salary that will their major source of income. As such, this money is taxed at ordinary rates which leaves them often paying a higher percentage in taxes than their billionaire bosses.

Q:           Is a CPA essential if you want your taxes done right?

A:            This largely depends on who you are and your situation.

THE PAY A CPA SCENARIO:  Some folks just don’t know enough to handle their taxes themselves and there’s no shame in that.  And if you have a high income, own a business (or are self-employed), or have investments, paying a professional is the way to go. The tax code is incredibly confusing, changes yearly and often times only a professional will know how to make the laws work in your favor.  But even if you could handle your taxes, you may not want to. I could spend hours filing my taxes myself, as a financial planning professional I certainly have the wherewithal to do it. But why should I? I know in my own case I’m happier paying someone to it because I will make more money putting that time into my career than I would save by filing on my own.

THE DIY SCENARIO: If you are working one job and just taking the standard deduction, basic tax software should suffice.

It never ceases to amaze me that every spring, so many of us are shocked, shocked, that tax time is here once again. After a few times around this block, you’d think we’d be used to it by now, but no. When it comes to lessening the trauma, my advice is pretty simple (not that everyone will take it). Keep your financial records organized and updated throughout the year; reconciling your accounts on a monthly basis is an excellent way to do this.  And if you just can’t manage that, then find yourself a qualified professional you trust who can.

When is April 15^th again?  Live for Today, Plan for Tomorrow.  Don’t put off filing your taxes they won’t go away.

DAVID RAE, CFP®, AIF® is a Los Angeles-based financial planner with DRM Wealth Management, a regular contributor to Advocate Magazine, Huffington Post, Investopedia not to mention numerous TV appearances.  He helps smart people across the USA get on track for their financial goals.  For more information visit his website at www.davidraefp.com

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