Tax exclusion vs. tax deduction vs. tax credit

Both employers and consumers can take advantage of several tax reductions when it comes to healthcare costs. Tax reductions can take the form of exclusions, deductions, or credits, each of which have different structures and effects on individual income tax liabilities.

So what’s the difference between each of these tax reductions? While all three forms can reduce the amount of taxes a person owes, some reduce your tax liability and other reduce your tax bill.

In this blog, we’ll go over the following three tax reductions:

• Tax exclusions
• Tax deductions
• Tax credits

What are tax exclusions?

First, let’s talk about tax exclusions. A tax exclusion reduces the amount of money you file as your gross income, which ultimately reduces the total amount of taxes you owe for the year.

Certain forms of compensation are excluded from taxable income, providing a subsidy for the excluded amount. Tax exclusions can include certain forms of retirement income, federal subsidies, and insurance benefits.

For example, employers’ contributions to a health reimbursement arrangement (HRA) are exempt from federal income and payroll taxes. Employees’ reimbursements are also exempt from income taxes as long as their individual health insurance plan meets minimum essential coverage (MEC).

If you think a tax-advantaged HRA is right for your organization, take our HRA quiz to learn more!

What are tax deductions?

Next, let’s look at tax deductions. A tax deduction is an expense that is subtracted from your gross income when calculating taxable income, which reduces tax liability in proportion to your tax bracket. There are many types of standard tax deductions, so be sure you are using them to your greatest advantage.

All taxpayers may subtract certain types of income or expenses—or above-the-line deductions—from their total income to get their adjusted gross income. These deductions may differ based on family status or other personal factors. For example, self-employed individuals may deduct the full cost of their health insurance from their income.

For the 2022 tax year, the standard deduction is $12,950 for single filers and married filing separately, $25,900 for joint filers and $19,400 for head of household. Those who can deduct more than the standard deduction should do so.

Tax liabilities are determined by calculating which tax bracket you fall into based on the taxable income after you make these deductions. For the 2022 tax year, these brackets range from 10% to 37%. The value of tax exclusions and deductions generally depends on an individual’s marginal tax rate.

What are tax credits?

Lastly, there are tax credits. Tax credits are different from deductions and exemptions because credits reduce your tax bill directly. After calculating your total taxes, you can subtract any qualifying credits.

There are many different types of credits and all reduce your tax liability dollar for dollar. For example, a $1,000 tax credit reduces your tax bill by $1,000. Reviewing all the options may be time-consuming, but could also be very profitable for you and your business.

Most tax credits are nonrefundable, meaning that the actual credit can’t exceed the taxpayer’s income tax liability. Because lower-income individuals generally owe less income taxes, they are less likely to benefit from nonrefundable tax credits. However, some tax credits are refundable, which allow those to receive the entire credit regardless of their liability.

For example, premium tax credits are one type of tax credit that makes it so no American will ever pay more than 8.5% of their household income for health insurance. The premium tax credit is refundable so taxpayers who have little or no tax liability can benefit.

If you offer an HRA to your employees, you’ll want to make sure your health benefit will work for those employees that have premium tax credits. HRA allowances and premium tax credits can both pay for health insurance premiums so employees must account for both.

Coordinating tax credits with your HRA is different if you have a qualified small employer HRA (QSEHRA) versus an individual coverage HRA (ICHRA), so check the guidelines carefully.

Find out how you can make your premium tax credit work with your HRA!

Examples of tax reductions

There are a number of tax credits and deductions you might be able to claim and exclusions that may apply to you. While there are many more than are included here, we compile more common business tax exclusions, deductions, and credits below.

Conclusion

When tax season arrives, everyone wants to know the most effective ways to lower their tax burden. Consumers can get big savings on their taxes if they understand the ways in which they can exclude, deduct, or receive credits for medical expenses. If you have questions while filing your tax return, we recommend you consult your tax or financial advisor to understand how to get the biggest bang for your buck.

This article was originally published on December 21, 2020. It was last updated January 31, 2022.