Much of the general public — and even founders — tend to avoid understanding taxes.
In my experience, most people hand everything off to an online tax service or their CPA and move on. No shame on them — having a good accountant or utilizing Turbo Tax is a perfectly acceptable option. I’ve used plenty of online tools.
But there is a difference between outsourcing the execution of your taxes and understanding what is actually being applied to your return. If you have a baseline understanding of your taxes, you can ask better questions, catch things that might be missed, and make smarter decisions throughout the year rather than at tax time in the spring.
Starting at the basic level, having a strong understanding of tax deductions and tax credits and how they work can be immensely helpful.
Tax deductions
A tax deduction reduces the amount of income you are taxed on. It does not reduce your tax bill dollar for dollar.
If you are in the 22% tax bracket and you take a $1,000 deduction, you do not save $1,000 in taxes. You save $220 — because $1,000 less of your income is being taxed at 22%. The deduction reduces your taxable income, and your tax bill is calculated on that lower number. The higher your tax bracket, the more valuable a deduction becomes. A $1,000 deduction saves someone in the 37% bracket $370, compared to $120 for someone in the 12% bracket.
Tax deductions fall into two categories — above-the-line and below-the-line.
Above-the-line deductions can be used regardless of whether you take the standard deduction or itemize. They reduce your adjusted gross income, or AGI. Think of AGI as the starting point from which everything else is calculated. If you earned $50,000 and had $5,000 in above-the-line deductions, your AGI would be $45,000 — and that is the number used to calculate your tax.
Common above-the-line deductions include contributions to traditional IRAs and qualified retirement plans like a SEP IRA, SIMPLE IRA, or Solo 401(k). Roth IRA contributions are not deductible. Student loan interest — up to $2,500 — is also above-the-line, though it begins to phase out at $75,000 of modified AGI for single filers and $155,000 for those married filing jointly, so higher-earning founders may not qualify.
Contributions to a health savings account are above-the-line as well. For sole proprietors, business expenses are also above-the-line deductions, making them particularly valuable for founders running their businesses on Schedule C.
Below-the-line deductions are either the standard deduction or your itemized deductions — whichever is larger. For 2026, the standardized deduction is $32,200 for married filing jointly, $24,150 for head of household, and $16,100 for single filers or married filing separately.
If your itemized deductions — which can include mortgage interest, charitable donations, state and local taxes, and property taxes — total more than the standard deduction, you itemize. Typically, the more you earn, the more likely you are to itemize. If you’re not a part of the itemizing club, don’t worry, yours truly is not a member either.
After your above-the-line deductions reduce your AGI, and your standard or itemized deduction is subtracted from that, what remains is your taxable income. That is the number your tax is ultimately calculated from.
Tax credits
A tax credit is different from a deduction in one important way — it reduces your actual tax bill directly, not your taxable income. If you owe $2,000 in federal taxes and you qualify for a $1,000 tax credit, you’d owe $1,000. Credits decrease your tax bill dollar for dollar.
This makes tax credits generally more powerful than deductions of the same dollar amount. A $1,000 credit saves you exactly $1,000 regardless of your tax bracket. A $1,000 deduction saves you somewhere between $100 and $370, depending on where you fall in the tax brackets.
There are three types of tax credits worth understanding.
A nonrefundable tax credit can reduce your tax liability all the way down to zero — but not below it. If you have a $500 tax liability and $750 in nonrefundable credits, your liability goes to zero, and the remaining $250 simply disappears. You do not get it back. Examples include the Lifetime Learning Credit, the Adoption Credit, and the Foreign Tax Credit.
A refundable tax credit can reduce your tax liability below zero — meaning if the credit exceeds what you owe, you receive the difference as a refund. If you owe $500 and have a $750 refundable credit, your liability drops to zero, and you receive a $250 refund. If you are already owed a refund, the credit is added on top. The Earned Income Tax Credit and the Premium Tax Credit are the most common examples.
A partially refundable credit is a combination of both — a portion is refundable, and a portion is not. The Child Tax Credit and the American Opportunity Tax Credit are the most common examples. With the Child Tax Credit, a portion can be refunded even if it exceeds what you owe. With the American Opportunity Tax Credit, up to 40% of the credit is refundable.
Know your tax return!
As a business owner, I find value in understanding my tax return and where there might be blind spots. Not every founder has the time or inclination to engage at a high level with their CPA. But I do think that if more people had to work through their own return at least once, they would come away with a much stronger grasp of how deductions and credits actually affect their bottom line — and a better understanding of how the tax system works overall.
As a founder, the most practical application of this knowledge is being able to have a meaningful conversation with your CPA. If you understand that your SEP IRA contribution is an above-the-line deduction that reduces your AGI, and that your AGI affects everything from your eligibility for certain credits to your estimated tax payments, you start to see how these pieces connect. You ask better questions. You catch things that might otherwise slip through.
Tax planning should be proactive, not reactive. The decisions that affect your tax bill are made throughout the year — when you contribute to a retirement account, when you make a business purchase, when you time income or expenses. By the time April rolls around (March for S-Corps and Partnerships), most of the opportunities to reduce your tax bill have already passed. Working with a CPA is important. Working with a financial advisor who coordinates with your CPA is even better — because the goal is to make sure nothing falls through the cracks and there are no surprises.
*This is not meant to be tax advice and is for general information purposes only.
Did you know?
When asked whether a $1,000 tax credit or a $1,000 tax deduction was more valuable, 64% of survey respondents answered incorrectly or were unsure.
Something to ponder…
Do you have enough basic tax knowledge to have a productive conversation with your CPA — or are you simply trusting that everything is being handled correctly?
Ready to optimize and better understand your taxes? Schedule a free consultation with Texel Compass.