For some of us, the only thing that gets less complicated about tax season is knowing the exact deadline date. Before April 15th, it’s every American taxpayer’s civic duty to gather all of their financial documents and report their annual earnings to the government in the form of a tax return. Whether you’re outsourcing your tax help to a professional or plan to learn the ropes yourself, it’s always a good idea to educate yourself on the many complex tax terms that come up every year.
Finances are complicated. Between all of the number crunching and document scouring, it can be difficult to get a firm grasp on what exactly to expect out of tax season. Take tax credit vs. tax deduction for example. They’re both excellent ways to score additional tax breaks (if you qualify, of course), but how can you know if you qualify if you don’t know what they are?
Take the confusion out of tax season and score bigger— we’ll do the heavy lifting. Here’s a quick and comprehensive breakdown of tax credit vs tax deduction.
- What is a Tax Credit?
- What is a Tax Deduction?
- Tax Credit vs. Tax Deduction: What’s the Difference?
- Tax Credit Examples
- Tax Deduction Examples
- Deduction vs Credit: Which is Better?
What is a Tax Credit?
A tax credit is a type of tax incentive that reduces the amount of taxes you owe, dollar for dollar. They’re subtracted from your tax liability instead of taxable income. For example, say you owe $4,500 in taxes, but qualify for a $1,500 tax credit; the applied tax credit would reduce your tax liability by $1,500.
However, depending on the tax credit, yours may be non-refundable. In the case that you qualify for a $1,500 non-refundable tax credit but only owe $1,300 in taxes, the extra $200 will not be included in your final refund check.
On the other hand, a refundable tax credit will allow you to keep the extra credits remaining from your subtracted sum. Refundable tax credits are generally the ones that help boost that money back on your tax return.
What is a Tax Deduction?
A tax deduction is a deduction that lowers your annual taxable income. Tax deductions work to lower your taxable income by adhering to the percentage of your highest federal income tax bracket. For example, if you qualify for a $1,000 tax deduction but fall within Trump’s new tax bracket that pays a 22% tax rate, you’ll see a $220 reduction on your taxes.
Tax deductions are the result of tax-deductible expenses or exemptions that help lower your taxable income. The most common deduction is the standard deduction. The standard tax deduction is one that all taxpayers qualify for, effectively ensuring that all taxpayers have a portion of income that is not subject to federal income tax. Depending on your filing status, your standard deduction amount will vary.
Tax Credit vs Tax Deduction: What’s the Difference?
The core differences between tax credits and tax deductions are as follows:
- Credits are dollar-for-dollar amounts whereas deductions are tax bracket-dependent percentages
- Tax credits are subtracted from tax liability whereas tax deductions are subtracted from taxable income
- All tax credits have strict IRS qualification guidelines whereas all taxpayers qualify for standard deductions
- Tax credits can either be refundable or nonrefundable, this does not apply to deductions
- Tax deductions are adjusted before tax rate application whereas tax credits are adjusted after due amounts are finalized
Deduction vs. Credit: Which is Better?
Since tax credits offer dollar-for-dollar subtraction amounts, they are generally considered the better tax reduction method. In essence, tax credits directly reduce the sum of taxes you owe whereas tax deductions are dependent on your marginal tax bracket.
Tax Credit Examples:
Child Tax Credit: Depending on your filing status and income bracket, you may be eligible to earn up to $1,000 in tax credits per child. In order to be completely IRS eligible for child tax credit, the child must be claimed as a dependent on your tax return, under the age of 17, and living with you for a certain percentage of the year.
Residential Energy Credit: Being eco-friendly pays off too! Energy tax credits apply for solar panel installation, energy-efficient air-conditioning system installation, and geothermal heat pump installation could earn a generous 30% of installation cost credit.
Advanced Premium Tax Credit: Created to assist those within certain income limits, the advanced premium tax credit helps taxpayers pay pricey health insurance premiums when they purchase coverage through the HealthCare.gov exchange. The value of the tax savings are based on a sliding scale and accounts for household size and marital status in addition to income level.
Lifetime Learning Credit: In order to qualify for the Lifetime Learning credit, you must have made tuition and fee payments to a post-secondary school during the tax year. In fact, you can claim 20% of the first $10,000 paid toward tuition and fees for a $2,000 dollar-for-dollar credit.
Credit for the Elderly or the Disabled: Only applicable for taxpayers over the age of 65 years old or retired on permanent disability with taxable income, credit for the elderly or the disabled come with considerably low income limits, and can be as valuable as $7,500.
Earned Income Tax Credit: Depending on your dependency, marital, and income-level status, an Earned Income tax credit can grant you a dollar-for-dollar credit amount between $519 and $6,431. If your AGI is less than $55,000, this could be the hefty tax break you’re looking for.
Tax Deduction Examples:
Home Mortgage Interest: Yes, there are tax deductions for selling your home! The mortgage interest tax deduction allows homeowners to reduce their taxable income by the amount of mortgage interest you pay— effectively cutting your overall federal income tax.
Investment Interest Expenses: This tax deduction applies to any interest accrued on money borrowed to purchase a property that will generate investment income. This could be interest, annuities, royalties, or dividends.
Charitable Contributions: Donations in many eligible forms qualify as tax deductible from your taxable income. You are able to subtract the value of your charitable gifts from your taxable income to score a sweeter tax break.
Educator Expenses: School teachers, professors, or other eligible educators are able to deduct up to $250 spent on classroom supplies.
Student Loan Interest: Students and former students with student loans that accrue interest are able to deduct up to $2,5000 (depending on bracket) from their taxable income if interest was paid during the tax year.