How are Tax Credits and Tax Deductions Different?

Tax credits and tax deductions are two great ways to help save money when it comes time to file your taxes. However, the two tax-saving mechanisms work affect your yearly tax bill very differently. So, what is the difference between a tax cred and a tax deduction?

Tax credits and tax deductions affect your overall tax liability in different ways. A tax credit is subtracted from your total taxes after your tax liability has been assessed. A tax deduction reduces the amount of your income that is subject to taxes.

In this article, we will take a deeper dive into how tax credits and tax deductions work. Additionally, we will look at how to utilize tax credits and deductions to help you save money.

What is a Tax Deduction?

A tax deduction decreases the amount of your income that is subject to taxes before your tax liability is assessed. 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 example below:

With Tax Deductions Without Tax Deductions
Adjusted Gross Income $100,000 $100,000
Tax Deductions $12,000 $0
Taxable Income $88,000 $100,000
Taxes owed (25% tax rate) $22,000 $25,000
Total Savings $3,000

 

As you can see the deduction was applied to the AGI before calculating the taxes owed. Therefore, the tax rate was applied to the new total of $88,000. This resulted in a whopping $3,000 of tax savings.

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 allows you to list each individual deductible expense that the IRS allows you to take. You have to keep track of your expenses throughout the year, which can be extremely burdensome. However, it can also save you a lot of money.

A standard deduction is a standard deduction that the IRS permits everyone to take. You can claim it automatically and don’t need to provide any supporting documentation. The deduction varies based on filing status:

Filing Status 2021 2022
Single $12,550 $12,950
Married, filing jointly $25,100 $25,900
Married, filing separately $12,550 $12,950
Head of household $18,800 $19,400

 

You are only able to claim an itemized deduction or a standard deduction. You cannot file a combination of the two.

What is a Tax Credit?

A tax credit allows you to reduce the amount of taxes that you owe the IRS directly. This reduction is applied to the taxes that you owe after your total tax liability has been assessed on your taxable income.

Let’s look at the example below:

With Tax Credits Without Tax Credits
Adjusted Gross Income $100,000 $100,000
Tax Deductions $0 $0
Taxable Income $100,00 $100,000
Taxes owed pre-tax credits (25% tax rate) $25,000 $25,000
Tax Credit $5,000 $0
Taxes owed (post-credits) $20,000 $20,000
Total Savings $5,000

 

As you can see in the example above, the credit is applied directly to the taxes you owed. Therefore, if you have $5,000 in tax credits, that’s how much money you save.

What is the Difference Between a Refundable and Nonrefundable Tax Credit?

There are two general groupings of tax credits: refundable and nonrefundable. A refundable tax credit allows you to extend past your tax liability. Meaning that the IRS will refund you for any tax credit that exceeds more than the taxes you would have owed.

A nonrefundable tax credit is only applied to your tax liability. That means that even if you have tax credits that are worth more than the taxes you would’ve owed the IRS you wouldn’t get refunded for that money.

In essence, refundable tax credits are much more valuable than nonrefundable tax credits if you have more credits worth more than your tax liability.

Which is Better a Tax Credit or a Tax Deduction?

Tax credits and tax deductions are great ways to save money. 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 look at our previous examples side by side:

No Deductions or Credits With Just Tax Credits With Just Tax Reductions With Tax Reductions & Credits
Adjusted Gross Income $100,000 $100,000 $100,000 $100,000
Tax Deductions $0 $0 $12,000 $12,000
Taxable Income $100,000 $100,00 $88,000 $88,000
Taxes owed pre-tax credits (25% tax rate) $25,000 $25,000 $22,000 $22,000
Tax Credit $0 $5,000 $0 $5,000
Taxes owed (post-credits) $25,000 $20,000 $22,000 $17,000
Total Savings $5,000 $3,000 $8,000

 

As you can see from the chart, a combination of both tax credits and tax deductions ultimately saves you the most money.

What are Common Types of Tax Credits?

Tax credits can change yearly, but there are a ton of tax credits that are available if you are eligible.

Some of the more common tax credits ones include:

  • Child tax credit
  • Earned income credit
  • Lifetime learning credit
  • Credit for other dependents
  • 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 many more tax deductions available than tax credits. Of course, not everyone will qualify for most of them; however, some commonly claimed deductions include:

  • Moving expenses
  • Out-of-pocket charitable contributions
  • IRA and 401(k) deduction
  • State and local taxes
  • Student loan interest paid by your or someone else
  • Gambling loss

The list seems almost endless. Check the IRS website to find the tax deductions that you may be able to qualify for.

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 are eligible for can be extremely overwhelming. Missing a deduction or credit could mean that you are paying more on your taxes than you should be.

We can assist you in catching every credit and deduction that you are qualified for. Reach out today to avoid combing through the IRS guidelines and have us do all the work for you.

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