As you know, tax credits and tax deductions can help reduce your overall income tax liability to federal and state governments. Credits are generally designed to encourage or reward certain types of behavior that are considered beneficial to the economy, the environment or to further any other purpose the government deems important. In most cases, credit cover expenses you pay during the year and have requirements you must satisfy before you can claim them. Every year, millions of taxpayers search for credits and deductions that can help them save money. While you should take advantage of as many of these as possible, don’t overlook the fact that tax credits and deductions are not the same thing. There are a few basic differences between tax credits and tax deductions. Tax credits provide a dollar-for dollar reduction of your income tax liability. This means that a $1,000 tax credit saves you $1,000 in taxes. On the other hand, tax deductions lower your taxable income and they are equal to the percentage of your marginal tax bracket. For instance, if you are in the 25% tax bracket, a $1,000 deduction saves you $250 in tax (0.25 x $1,000 = $250).
Tax deductions and tax credits can both reduce an individual’s income tax liability, but they do it in different ways. Tax deductions reduce taxable income; their value thus depends on the taxpayer’s marginal tax rate, which rises with income. Because deductions cannot reduce taxable income below zero, their value is limited to the filer’s tax liability before applying the deduction. In contrast, tax credits directly reduce a person’s tax liability and hence have the same value for all taxpayers with tax liability at least equal to the credit. In addition, some credits are refundable; they are not limited by the taxpayer’s tax liability. As a general rule for policy, tax deductions make most sense for items that represent reductions in ability to pay tax, such as casualty losses. Credits are more appropriate for subsidies provided through the tax system.
- Tax credits are subtracted not from taxable income but directly from a person’s tax liability; they thus reduce taxes dollar for dollar. As a result, credits have the same value for everyone who can claim their full value.
- Most tax credits are nonrefundable; that is, they cannot reduce a person’s tax liability below zero. As a result, low-income tax filers often cannot get the full benefit of the credits for which they qualify. Some tax credits, however, are fully or partially refundable: if their value exceeds a person’s tax liability, the excess is paid to the filer. The earned income tax credit (EITC) is fully refundable; the child tax credit (CTC) is refundable only to the extent that the filer’s earnings exceed a specified threshold
A tax credit is always worth more than a dollar-equivalent tax deduction, because deductions are calculated using percentages. Referring to the numbers above, you can see that a $1,000 credit offers $750 more in savings than a $1,000 deduction.
Let take a closer look at both tax credits and tax deductions.
Tax credits can help reduce your liability dollar-for-dollar. However, they cannot reduce your income tax liability to less than zero. In other words, your gross income tax liability is the amount you are responsible for paying before any credits are applied.
The majority of tax credits are non-refundable. With non-refundable tax credits, any excess amount expires in the year in which it was used, meaning that the additional amount is not refunded to you. There are some refundable tax credits, though, and these can be used to help grow your tax refund.
To get a better idea of how tax credits work and whether or not you qualify, you need to know what is available to taxpayers in your situation — such as your filing status, age, employment, and education. It is important to remember that just because you qualify for one type of tax credit does not mean that you qualify for the rest.
How much are tax credits worth? That depends on the particular tax credit you’re talking about. And just as the amount of each tax credit is different, so are the qualification guidelines. Since a credit helps reduce the amount of money that you pay in income tax, it is essential that you are 100% accurate with this information. If you are unsure of whether or not you qualify for a tax credit, it’s recommended that you check with a tax professional before claiming the credit on your income tax return.
While tax credits are less common than tax deductions, they are available for things such as adopting a child, buying a first home, child care expenses, home office expenses, and caring for an elderly parent. Additionally, there are various business tax credits that you may be able to consider.
As we learned earlier, tax deductions lower your taxable income, and they are calculated using the percentage of your marginal tax bracket. For example, if you are in the 25% tax bracket, a $1,000 tax deduction saves you $250 in tax (0.25 x $1,000 = $250).
There are 2 main types of tax deductions: the standard deduction and itemized deductions. A taxpayer must use one or the other, but not both. It is generally recommended that you itemize deductions if their total is greater than the standard deduction.
The Standard Deduction
The standard deduction is a dollar amount that reduces your taxable income. It is typically adjusted up for inflation each year. Your standard deduction amount is based on your filing status and is subtracted from your AGI (adjusted gross income).
The standard deduction can be claimed on IRS Tax Form 1040, IRS Tax Form 1040A, or IRS Tax Form 1040EZ.
If you do not qualify for the standard deduction, you may choose to itemize your deductions. A taxpayer will usually itemize deductions if it offers them more benefits than the standard deduction (i.e., when the amount of qualified deductible expenses totals more than the standard deduction).
Note that some itemized deductions are based on a minimum (or “floor”) amount. This means that you can only deduct amounts that exceed the specified floor. There is also an income limit for taxpayers who itemize their deductions. If your AGI (adjusted gross income) exceeds a certain level, then a portion of itemized deductions is not permitted.
If you decide to itemize your tax deductions, it is important to keep detailed records of those itemized deductions ― including documentation for medical expenses, property taxes, charitable donations, mortgage interest, and non-business state income taxes.
You may use IRS Tax Form 1040 Schedule A to figure your itemized deductions, and attach it to your IRS Tax Form 1040 (but not Form 1040A or Form 1040EZ).
How tax credits work
A tax credit is a dollar-for-dollar reduction of the income tax you owe. For example, if you owe $1,000 in federal taxes but are eligible for a $1,000 tax credit, your net liability drops to zero. Some credits, such as the earned income credit, are refundable, which means that you still receive the full amount of the credit even if the credit exceeds your entire tax bill. Therefore, if you owe $400 in tax and claim a $1,000 earned income credit, you will receive a $600 refund.
Types of tax credits
There is an array of tax credits available to all types of taxpayers covering a wide range of expenses. As incentive for taxpayers to protect the environment, the federal government offers a credit for the cost of purchasing solar panels and wind turbines for use in your home or for when you install energy-efficient windows. To help families wanting to adopt a child, the federal adoption credit can reduce your tax bill for the costs you incur that are necessary to adopt a child. Other credits cover the expense of child and dependent care and for taxpayers purchasing their first home.
Comparing credits to deductions
Tax credits generally save you more in taxes than deductions. Deductions only reduce the amount of your income that is subject to tax, whereas, credits directly reduce your tax bill. To illustrate, suppose your taxable income is $50,000 and you have $10,000 in deductions, which reduces your taxable income to $40,000. If that $10,000 would have been taxed at a rate of 25 percent, then the deduction saves you $2,500 in tax. If the $10,000 was a tax credit instead of a deduction, your tax savings is $10,000 rather than $2,500.
The Bottom Line
So which is better? Neither. It really depends on your situation and what kind of tax savings you can claim. Both tax credits and tax deductions offer various benefits. They are simply different ways to reduce the amount of tax that you owe to the IRS. The main difference is that tax deductions are subtracted from your gross income, while tax credits are subtracted directly from the amount you owe.
All in all, both tax credits and deductions can help you pay less income tax. Your goal as a taxpayer should be to take full advantage of every tax credit and deduction that you qualify for. Just make sure you are actually eligible to claim the tax credit/deduction before marking it on your income tax return. Remember that misinformation on your tax return can trigger an IRS tax audit, so be careful. If you are unaware of which tax credits and deductions are available, consult with a tax professional who can show you the ropes.