Tax Breaks: What They Are and How They Work

Key takeaways
* Tax breaks reduce the amount of tax you owe through credits, deductions, exemptions, or exclusions.
* Tax credits reduce tax liability dollar for dollar; some refundable credits can produce a refund.
* Tax deductions lower taxable income and their value depends on your tax bracket.
* Many tax breaks phase out at higher income levels or require specific actions and documentation.

What is a tax break?

A tax break is any provision in the tax code that lowers an individual’s or business’s tax liability. Common forms are tax credits, tax deductions, exemptions, and income exclusions. Governments use tax breaks to promote economic activity or public policy goals (for example, encouraging education, homeownership, retirement saving, or disaster relief). Some organizations—such as many religious and charitable groups—receive broad tax-exempt status.

How tax breaks work

• Some tax breaks (like certain exclusions) apply automatically; others must be claimed on a tax return and have eligibility requirements.
• Rules and timeframes for tax breaks are set by law and regulation; Congress and tax authorities define who qualifies and how to claim benefits.
• Tax breaks can stimulate spending and investment by leaving more money in taxpayers’ hands or by incentivizing specific behaviors.

Types of tax breaks

Tax credits
* Directly reduce the tax you owe on a dollar-for-dollar basis.
* Example: If you owe $3,000 and claim a $1,100 credit, your tax due falls to $1,900.
* Refundable credits: can reduce your tax below zero and generate a refund.
* Used by individuals and corporations; many credits target policy goals (education, energy, child care, etc.).

Tax deductions
* Reduce the amount of income subject to tax (taxable income).
* The dollar value of a deduction equals the deduction amount multiplied by your marginal tax rate (a $1,000 deduction saves $220 if you’re in the 22% bracket).
* Most taxpayers choose between the standard deduction and itemizing deductions on Schedule A.
* Common itemizable deductions:
* Mortgage interest (limit generally applies — e.g., interest on up to $750,000 of mortgage debt for many recent loans)
* Unreimbursed medical and dental expenses exceeding 7.5% of adjusted gross income (AGI)
* State and local taxes (SALT), capped at $10,000
* Charitable contributions
* Casualty and theft losses (in limited situations)
* Gambling losses (to the extent of gambling winnings)

Tax exclusions
* Exclude certain income from taxable income entirely.
* Examples:
* Life insurance proceeds and child support payments (generally excluded)
* Interest on municipal bonds
* Employer-paid health insurance premiums (typically excluded from federal income and payroll taxes)
* Home sale gain exclusion: up to $250,000 ($500,000 married filing jointly) of gain on the sale of a main home if you meet ownership and use tests
* Foreign earned income exclusion: $126,500 for 2024 and $130,000 for 2025 (amounts apply if you meet residency or bona fide residence tests)

Credits vs. deductions: which is better?

• Tax credits are generally more valuable because they reduce tax owed directly.
• Deductions reduce taxable income and thus save an amount equal to the deduction times your marginal tax rate.
• Refundable credits can be particularly valuable because they can result in refunds even if no tax is owed.

Other points to know
* Personal exemption: suspended (reduced to $0) for tax years 2018 through 2025 under the Tax Cuts and Jobs Act.
* Annual gift tax exclusion: $18,000 per recipient for 2024 and $19,000 for 2025.
* Many tax breaks phase out at higher income levels; eligibility often depends on income, filing status, and specific activity.

Who qualifies for tax breaks?

• Qualification varies by tax break. Many credits and deductions favor middle- and lower-income taxpayers and phase out as income rises.
• Others are available to taxpayers who meet activity-based tests (for example, contributing to retirement accounts, buying a home, pursuing education, or conducting business in certain industries).
• Proper documentation and claiming the break on the tax return are usually required.

Practical tips

• Keep records and receipts for deductions and credits you plan to claim.
• Compare the standard deduction with itemized deductions each year to see which gives the larger benefit.
• Be aware of phaseouts and eligibility rules before relying on a tax break.
• Consider consulting a tax professional for complex situations or when large tax benefits are at stake.

Bottom line

Tax breaks are tools in the tax code that can meaningfully reduce what you owe. Understanding the difference between credits, deductions, and exclusions—and knowing which ones you qualify for—helps you minimize tax liability and make informed financial decisions.