You probably know that claiming tax deductions and tax credits can help lower the amount of your tax bill, but do you know the difference?
Tax Credits vs. Tax Deductions
While the end result of deductions and credits may be the same — you pay less in taxes — they work in very different ways.
Tax deductions reduce your taxable income, while tax credits directly reduce your tax bill.
Tax credits give you a dollar-for-dollar reduction.
For example, a tax credit of $1,000 actually lowers your tax bill by $1,000.
On the other hand, tax deductions reduce how much of your income is subject to taxes.
Deductions lower your taxable income by the same percentage as your tax bracket.
For example, if you are in the 22% tax bracket, a $1,000 deduction saves you $220.
REFUNDABLE VS NONREFUNDABLE
Some tax credits are non-refundable.
That means that if you don’t owe a lot in taxes, you can’t take the full credit because it is capped at the amount of your liability.
For example, a $600 tax bill combined with a $1,000 non-refundable credit doesn’t get you a $400 tax refund check. It only lowers your liability to zero.
Some tax credits are refundable.
Suppose you qualify to take refundable tax credits. In that case, things such as the Earned Income Tax Credit or the Child Tax Credit — the credit value goes beyond your tax liability and can result in a refund check.
Keep in mind, the IRS has specific criteria you must meet to qualify for both non-refundable and refundable credits.
Here’s a list of some common tax credits:
- Earned Income Tax Credit
- American Opportunity Tax Credit
- Child and Dependent Care Credit
- Adoption Credit
- Child Tax Credit
- Premium Tax Credit
- Saver’s Credit
- Lifetime Learning Credit
And here are some examples of deductible expenses you can take if you itemize:
- Charitable donations
- Mortgage loan interest
- Medical and dental expenses
- Tuition and fees
- Contributions to a traditional IRA
- Contributions to health savings accounts (HSAs)
- Mileage for business travel
- Teacher’s educational expenses
- Property and real estate taxes
Keep in mind most people will take the standard deduction instead of these itemized deductions.
Both the standard or itemized deductions work by reducing your taxable income, as mentioned above.
However, the standard deduction is just what it sounds like – a fixed, base-level amount you can use if you don’t qualify for a higher amount through itemized deductions.
The standard deduction is a fixed amount based on your filing status – married filing jointly, single, head of household, and so on.
The 2020 amounts are as follow:
- $12,400 for single or separate filers
- $18,650 for head of household filers
- $24,800 for married filing jointly.
- These amounts are higher if you’re 65 or over, or blind.
Bottom-Line
Tax credits are generally considered better than tax deductions because they directly reduce the tax you owe.
We know that no one wants to pay more than their fair share of income tax.
That’s why you should always consult a tax professional when preparing your taxes.
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