Tax Credits vs. Tax Deductions
Use Tax Breaks to Lower Your IRS Bill
As you probably know, tax credits and tax deductions can help reduce your overall income tax liability. Every year, millions of taxpayers search for credits and deductions that can help them save money. While you should take advantage of all the tax breaks you’re eligible for, don’t overlook the fact that tax credits and tax deductions are not the same thing.
There are a few basic differences between tax credits and tax deductions. Tax credits provide a dollar-for dollar reduction of your income tax liability. This means that a $1,000 tax credit saves you $1,000 in taxes. On the other hand, tax deductions lower your taxable income and they are equal to the percentage of your marginal tax bracket. For instance, if you are in the 10% tax bracket, a $1,000 deduction saves you $100 in tax (0.10 x $1,000 = $100).
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A tax credit is always worth more than a dollar-equivalent tax deduction, because deductions are calculated using percentages. Referring to the numbers above, you can see that a $1,000 credit offers $900 more in savings than a $1,000 deduction.
Let take a closer look at both tax credits and tax deductions.
Tax credits can help reduce your liability dollar-for-dollar. However, they cannot reduce your income tax liability to less than zero. In other words, your gross income tax liability is the amount you are responsible for paying before any credits are applied.
The majority of tax credits are non-refundable, which means they will be subtracted from your tax balance, but they cannot reduce your income tax liability to less than zero. With non-refundable tax credits, any excess amount expires in the year in which it was used, meaning that the additional amount is not refunded to you. However, there are some refundable tax credits, and these can be used to increase your tax refund.
To get a better idea of how tax credits work and whether or not you qualify, you need to know what is available to taxpayers in your situation — such as your filing status, age, employment, and other factors. It is important to remember that just because you qualify for one type of tax credit does not mean that you qualify for the rest.
How much are tax credits worth? That depends on the particular tax credit you’re talking about. And just as the amount of each tax credit is different, so are the qualification guidelines. Since a tax credit helps reduce the amount of money that you pay in income tax, it is essential that you are 100% accurate with this information. If you are unsure of whether or not you qualify for a tax credit, it’s recommended that you check with a tax professional before claiming the credit on your income tax return.
While tax credits are less common than tax deductions, they are available for things such as adopting a child, buying a first home, childcare expenses, home office expenses, and caring for an elderly parent. Additionally, there are various business tax credits that you may be able to consider if you are a business owner.
As we learned earlier, tax deductions lower your taxable income, and they are calculated using the percentage of your marginal tax bracket. For example, if you are in the 10% tax bracket, a $1,000 tax deduction saves you $100 in tax (0.10 x $1,000 = $100).
There are two main types of tax deductions: the standard deduction and itemized deductions. A taxpayer must use one or the other, but you cannot both. It is generally recommended that you itemize deductions if their total is greater than the standard deduction.
The Standard Deduction
The standard deduction is a dollar amount that reduces your taxable income. It is typically adjusted up for inflation each year. Your standard deduction amount is based on your filing status and is subtracted from your AGI (adjusted gross income).
For tax year 2019, the standard deduction is as follows:
- $12,200 for Single filers
- $24,400 for Married Couples Filing Jointly
- $12,200 for Married Couples Filing Separately
- $18,350 for Head of Household filers
The standard deduction can be claimed on IRS Tax Form 1040.
If you don’t want to claim the standard deduction, you may choose to itemize your deductions instead. A taxpayer will usually itemize deductions if it offers them more benefits than the standard deduction (i.e., when the amount of qualified deductible expenses totals more than the standard deduction).
Note that some itemized deductions are based on a minimum (or “floor”) amount. This means that you can only deduct amounts that exceed the specified floor. There is also an income limit for taxpayers who itemize their deductions. If your AGI (adjusted gross income) exceeds a certain level, then a portion of itemized deductions is not permitted.
If you decide to itemize your tax deductions, it is important to keep detailed records of those itemized deductions – including documentation for medical expenses, property taxes, charitable donations, mortgage interest, and non-business state income taxes.
You may use IRS Tax Form 1040 Schedule A to report your itemized deductions, and attach it to your Form 1040 tax return.
RELATED: 2020 Federal Tax Calendar
The Bottom Line
So which is better? Neither. It really depends on your situation and what kind of tax savings you qualify for. Both tax credits and tax deductions offer various benefits. They are simply different ways to reduce the amount of tax that you owe to the IRS. The main difference is that tax deductions are subtracted from your taxable income, while tax credits are subtracted directly from the amount you owe.
All in all, both tax credits and deductions can help you pay less income tax. Your goal as a taxpayer should be to take full advantage of every tax credit and deduction that you qualify for. Just make sure you are actually eligible to claim the tax credit/deduction before marking it on your income tax return. Remember that misinformation on your tax return can trigger an IRS tax audit, so be careful. If you are unaware of which tax credits and deductions are available to you, consult with a tax professional who can show you the ropes.