Tax Credit vs. Deduction: What’s The Difference And Which Is Better?
Saving money by lowering your tax bill is one of the more satisfying endeavors of adulting. But what’s the best way to ensure Uncle Sam issues you a refund check?
The secret is in leveraging both tax deductions and tax credits to ease your tax burden.
Before you start stumbling through your tax return, let’s clear up any misconceptions about the differences between a tax credit and a tax deduction and how both work to lower your tax liability and your tax rate in different ways.
What Is A Tax Credit?
A tax credit directly reduces the taxes you owe the IRS (Internal Revenue Service) by providing a dollar-for-dollar reduction of your actual tax bill. In the simplest terms, if you owed $2,500 on your tax return but are claiming tax credits of $1,500, your taxes due would instead total $1,000.
Because they are direct credits against your tax bill, tax credits greatly reduce your taxes for a given tax year and help you pay less tax overall.
How Do Tax Credits Work?
One key thing to understand is the difference between a refundable credit and a nonrefundable credit. Refundable tax credits reduce your tax liability past zero and can result in being issued a refund check. Nonrefundable tax credits will take your tax bill to zero but won’t trigger a refund. Some tax credits are partially refundable, which usually means one portion of the tax credit is eligible for a refund while the rest is not.
For example, if you have a $1,000 tax bill and claim a $1,200 refundable tax credit, the IRS cuts you a check or issues you a refund of $200. If that same tax credit is nonrefundable, your tax bill would be $0, but you wouldn’t receive a tax refund.
The IRS also has specific qualifications and terms tax credit recipients must meet. These qualifications are related to income, tax filing status, and other criteria.
5 Common Tax Credits
Tax credits fall into several categories, but here’s a snapshot of the most popular ones that may apply to your financial tax situation.
Family And Dependent Credits
Two of the most frequently used tax credits are the child tax credit and the earned income tax credit (EITC). The child tax credit lightens your tax load for having a dependent under your care in the United States, and the earned income tax credit is for taxpayers who fall below the poverty line according to filing status. Child and dependent care credits, education credits, and adoption credits also fall into this category.
Clean Vehicle Credits
These credits are exactly what they sound like — tax breaks for those who invest in electric vehicles and other clean vehicles as specified by the IRS.
Income And Savings Credits
Several types of tax credits fall under this umbrella, but the most frequently used is the retirement savings contribution credit — commonly known as the saver’s credit — which credits you for contributions made to your individual retirement account. It’s limited to middle- and low-income earners.
Homeowner Credits
Tax credits available for homeowners include residential energy credits, home energy tax credits, and credits for energy-efficient home improvements.
Healthcare Credits
The IRS offers something called a Premium Tax Credit (PTC), which helps eligible individuals and families cover health insurance premiums purchased through the federal healthcare marketplace.
What Is A Tax Deduction?
Instead of taking money off your tax bill, tax deductions reduce your taxable income. How much a tax deduction lowers your tax liability depends on your tax bracket.
Tax deductions can work both as above-the-line deductions or as itemized deductions. Above-the-line deductions are applied to your adjusted gross income (AGI) even if you use the standard deduction on your income tax return. Itemized deductions can only be used in place of the standard deduction in calculating the taxes you owe.
How Do Tax Deductions Work?
One of the biggest decisions taxpayers make is whether to itemize deductions or take what the IRS offers as a standard deduction. The standard deduction reduces what you owe by subtracting a flat dollar amount from your taxable income according to your filing status.
