What is the Difference Between a Tax Credit and Tax Deduction?
Each year as you file your taxes we look for ways to help minimize the taxes we owe to the IRS or maximize our tax return. You know that tax deductions and tax credits can help save you money, but what is the difference between the two mechanisms?
Tax credits and tax deductions affect your overall tax liability in different ways. A tax credit is a dollar-for-dollar reduction of the income tax that is owed. A tax deduction reduces how much of your income is subject to taxes.
In this article, we will take a deeper look at how tax credits and tax deductions work. Additionally, we will look at some common forms of both tax reduction mechanisms and ultimately which mechanism will save you the most money.
What is a Tax Credit?
A tax credit is a dollar-for-dollar reduction of the income tax that is owed. This reduction is applied to the taxes that you owe after your total tax liability has been assessed on your taxable income.
For example, let's say your taxable income is $80,000 in taxes with a tax rate of 25%. You would owe $20,000 in taxes. However, you have tax credits worth $2,000.
You would subtract $2,000 from the $20,000 worth of owed taxes. Therefore, you would end up owing $18,000 worth of taxes.
What is the Difference Between a Refundable and Nonrefundable Tax Credit?
There are two general categories of tax credits: refundable and nonrefundable. A refundable tax credit allows you to go beyond your tax liability. Meaning that if you owe $10,000 in taxes and have $12,000 worth of refundable tax credits, the IRS would send you a check for $2,000.
A nonrefundable tax credit is only applied to your tax liability. Let's use the same scenario as above. If you owed $10,000 in taxes and had $12,000 worth of nonrefundable tax credits you would owe $0 in taxes but would not receive a refund check for the outstanding $2,000 in tax credits.
What is a Tax Deduction?
A tax deduction reduces the amount of your income that is subject to taxes. The deduction is applied to your adjusted gross income (AGI) and then you are taxed based on the new total.
Let's look at the same $80,000 income that we used in the tax credit example. If you have $2,000 worth of tax deductions, this would be subtracted from your taxable income of $80,000 to give you a new taxable income of $78,000.
If your tax rate is 25%, then you would owe $19,500 worth of taxes as opposed to $20,000 worth of taxes. In this case, the tax deduction saves you $500 on your end-of-year tax bill.
What is the Difference Between the Standard Deduction and an Itemized Deduction?
When claiming deductions on your taxes you have two options: claiming the standard deduction or completing an itemized deduction.
An itemized deduction is when you list each individual expense that the IRS allows you to take a deduct from your taxable income. It requires you to keep track of your expenses throughout the year and can be extremely cumbersome. However, it can also save you a lot of money.
A standard deduction is a standard amount that the IRS allows everyone to take. You can claim it automatically and don't need to provide any documentation. The deduction varies based on filing status:
|Married, filing jointly
|Married, filing separately
|Head of household
It's important to note that you are only able to claim to complete an itemized deduction or a standard deduction. You cannot file a combination of the two.
Which is Better a Tax Credit or a Tax Deduction?
Both are tax credits and tax deductions are great ways to save money if you use them effectively. Typically, you will save more money with a tax credit than a tax deduction. However, using a combination of both is the best way to save money.
Let's return to our example of having $80,000 in earnings with a 25% tax rate and $2,000 in tax deductions and $2,000 in tax credits.
First, we would subtract that $2,000 in tax deductions from the $80,000 in earnings to get $78,000. With a 25% tax rate, you would owe $19,500 in taxes.
However, you still get to take the $2,000 worth of tax credit away from the $19,500 to give you a total tax bill of $17,500. By combining both your tax credits and tax deductions you save $2,500 on your taxes.
What are Common Types of Tax Credits?
You may be wondering what type of tax credits are available to me? Tax credits can change from year to year, but there are dozens of tax credits that can be claimed if you are eligible.
Some of the more common ones include:
- Earned income credit
- Child tax credit
- Credit for other dependents
- Lifetime learning credit
- Adoption credit
- Low-income housing credit
For a complete list of available tax credits, you can visit the IRS website.
What are Common Types of Tax Deductions?
There are even more tax deductions available than tax credits. Of course, not everyone will qualify for most of them; however, some commonly claimed deductions include:
- Out-of-pocket charitable contributions
- Moving expenses
- Student loan interest paid by your or someone else
- State and local taxes
- Gambling loss
- IRA and 401(k) deduction
The list goes on and on. Check the IRS website to find the tax deductions that you may be able to take.
How Do I Make Sure I Get All the Credits and Deductions I'm Owed?
Trying to figure out which tax credits and deductions you can take can be extremely overwhelming. You don't want to miss out on saving money come tax time, but you also don't want to accidentally claim something as a credit or deduction that you weren't allowed to.
At irsextension.online we help you catch every credit and deduction that you are entitled to. Reach out to us today to figure which credits and deductions you can claim without the hassle of trying to decipher the IRS guidelines.
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