When it comes to filing your taxes, understanding the difference between tax credits and deductions can help you save money and reduce your overall tax liability. Both options can lower the amount you owe the government, but they work in different ways. Knowing how each one functions can make a big impact on your financial outcome come tax season.
In this post, our tax consultants will break down the key differences between tax credits and deductions, explain how they work, and offer tips on which may benefit you the most.
What Are Tax Deductions?
Tax deductions reduce your taxable income, meaning they lower the amount of your income that is subject to tax. By reducing your taxable income, you effectively lower the amount of tax you owe. Deductions are often related to specific expenses you’ve incurred throughout the year, such as:
- Mortgage interest
- Charitable contributions
- Student loan interest
- Medical expenses
For example, if you earned $60,000 in a year and qualified for $10,000 in deductions, your taxable income would drop to $50,000. The taxes you owe will then be calculated based on this lower amount.
There are two main types of deductions:
- Standard deduction: A set amount that reduces your taxable income. Most taxpayers choose this option if they don’t have enough itemized expenses to exceed the standard amount.
- Itemized deductions: Specific deductions for various expenses. These are used when the total of your itemized deductions is greater than the standard deduction.
What Are Tax Credits?
Tax credits directly reduce the amount of taxes you owe, making them highly valuable when you’re looking to lower your tax bill. Unlike deductions, which reduce taxable income, tax credits reduce your total tax liability dollar-for-dollar. There are two main types of tax credits:
- Non-refundable credits: These can reduce your tax liability to zero but won’t result in a refund if the credit is larger than the tax you owe.
- Refundable credits: These not only reduce your tax liability but can also provide a refund if the credit exceeds the amount of tax you owe.
For example, if you owe $1,500 in taxes and qualify for a $1,000 tax credit, your tax bill drops to $500. If it’s a refundable credit and your tax bill drops below zero, you could receive the difference as a refund.
Key Differences Between Tax Credits and Deductions
The primary difference between tax credits and deductions lies in how they reduce your tax burden. Deductions lower your taxable income, indirectly reducing your tax liability by placing you in a lower tax bracket. In contrast, credits directly reduce the amount of taxes you owe, often offering a more significant savings.
- Deductions: Reduce your taxable income. The benefit depends on your tax bracket (e.g., 10%, 22%, etc.). Higher income earners typically benefit more from deductions.
- Credits: Reduce your tax liability on a dollar-for-dollar basis, providing more immediate savings. Refundable credits can result in a tax refund if they exceed your liability.
Examples of Common Tax Credits and Deductions
Common Tax Credits:
- Earned Income Tax Credit (EITC): A refundable credit aimed at low-to-moderate-income workers.
- Child Tax Credit: A credit for families with qualifying children, with portions that may be refundable.
- Education Credits: Credits like the American Opportunity Tax Credit (AOTC) or Lifetime Learning Credit (LLC) can reduce your tax bill for qualified educational expenses.
Common Tax Deductions:
- Student Loan Interest Deduction: You can deduct up to $2,500 in student loan interest paid during the year.
- Medical Expense Deduction: Medical expenses exceeding 7.5% of your adjusted gross income (AGI) can be deducted.
- Charitable Contributions: Contributions to qualifying charities can be deducted if you itemize.
Which One Is Better for You?
Whether tax credits or deductions are more beneficial depends on your specific financial situation. In general:
- Tax credits tend to offer more direct savings, particularly if they’re refundable.
- Tax deductions can be helpful if you have significant qualifying expenses and are in a higher tax bracket.
For many people, a combination of both is often used to reduce their tax bill as much as possible. For example, you might claim the Child Tax Credit while also deducting student loan interest and medical expenses.
Conclusion
Understanding the difference between tax credits and deductions is essential for optimizing your tax return and ensuring you save as much money as possible. While deductions lower your taxable income, credits reduce your tax liability dollar-for-dollar, often providing a greater financial benefit. By knowing how to use both effectively, you can significantly reduce your tax bill and potentially even secure a refund.As you prepare your taxes this year, consider which credits and deductions you qualify for, and consult a tax professional if needed to ensure you’re making the most of your tax-saving opportunities.
