Knowing the difference between a tax credit and tax deduction can make a significant difference in the amount of taxes you owe.
A tax deduction reduces your taxable income before you figure how much you owe in taxes. If your income was $50,000 and had a deduction of $10,000, your Adjusted Gross Income is $40,000. Then you calculate how much taxes you owe.
A tax credit is subtracted after you calculate your tax liability. If your Adjusted Gross Income is $40,000 and you owe $2,500 in taxes and qualify for $1,000 in tax credits, you only owe $1,500.
Tax deductions and tax credits reduce your tax liability, but the difference is when they’re calculated on the tax return. Typically, suppose you must choose between a tax deduction and a tax credit. Usually, you will save more with a tax deduction if it drops you into a lower tax bracket. Always check with your tax professional when making tax decisions.
How Does a Tax Deduction Work?
Has someone ever tried to persuade you to spend money by saying, “don’t worry, it’s tax-deductible.” To most people, that sounds great, but they don’t really understand how it works when preparing your tax return.
When filling out your tax return, the form asks if you spent money on several deductible items:
- Health care expenses
- Retirement contributions
- Alimony payments
- Tuition and fees
- Moving expenses
- Self-employment taxes and expenses
- Educator expenses
- Student loan interest
- Gambling losses
- Taxes paid last year
These deductions only matter if you do not itemize your deductible expenses. For example, if you are self-employed, you might not have a significant overhead, except for health insurance, gas, and various office expenses. Or if you are employed by a company that pays you on a W2 form, you may have nothing to itemize at all.
When you enter how much of these you spent, add them up and subtract them from your income to determine your Adjusted Gross Income (AGI). Gross income is all of your income sources—adjusted means you’ve also factored in the deductible items.
Should I Itemize or Take the Standard Deduction?
In simple tax cases, it might be easiest to use the standard deduction.
A standard deduction is the portion of your income not subject to tax and can reduce your tax bill. You can use it instead of itemizing deductions. For some people, it provides a larger deduction than breaking it down line-by-line. Plus, you don’t have to prove anything with receipts except your income if you use the Standard deduction.
When you itemize, you must account for each item with a receipt. The IRS provides a worksheet called Schedule A that allows you to provide more detail about your tax-deductible things. If you have significant expenses, it might be better to itemize them for a deduction. If so, ignore the Standard deduction option. You can take whichever deduction is higher.
Deductions can decrease your AGI, and it might drop down into a lower tax bracket. In turn, your tax bill would reduce.
What is the Standard Deduction?
In 2019, the Standard deductions were:
- $12,200 for single or married filing separately
- $24,400 for married filing jointly or qualifying widow(er)
- $18,350 for the head of household
What is a Tax Credit?
After you complete your taxable income calculations, you find out how much you owe in taxes. Tax credits are subtracted from your tax liability.
The IRS recognizes two types of tax credits:
- A non-refundable tax credit means you will not receive a refund check if your credit exceeds your tax bill.
- A refundable tax credit means you will receive a refund check if the credit is more than what you owe.
The IRS specifies the criteria to qualify for both non-refundable and refundable credits.
Refundable Tax Credits
Refundable tax credits can provide you with income even if you have no tax liability and did not have any tax withheld.
Refundable tax credits include:
- Earned Income Tax Credit
- American Opportunity Tax Credit
- A portion of the Child Tax Credit
Credits can change year to year.
Non-Refundable Tax Credits
Non-refundable tax credits can reduce the amount you owe to zero. You will not receive a refund check if your credit exceeds your tax liability.
Non-refundable credits include:
- Adoption Credit
- Child and Dependent Care Credit
- Saver’s Credit
- Lifetime Learning Credit
- Plug-In Electric-Drive Motor Vehicle Credit
- Residential Energy Tax Credit
- Foreign Tax Credit
Tax deductions and tax credits can provide significant tax savings each year. When possible, speak with your tax professional for advice about which tax deductions and credits would be most beneficial for you and your family. You may discover new ways to save money that are legal and helpful!