Financial lingo can be quite confusing, especially when it comes to tax planning. One of the most common misunderstood terms are tax credit versus tax deduction. Both help lower your taxes but do so in different ways.
Below, we break down the difference between the two and tell you how you can take advantage of each.
What is a tax credit?
In simple terms, a tax credit is a dollar-for-dollar reduction of your tax liability. It is the amount of money you can subtract from the total tax you owe.
For example, a tax credit for $1,000 lowers your tax bill by $1,000.
Tax credits can be either refundable or non-refundable.
Refundable tax credits give you a refund, even if it is more than what you owe. Nonrefundable tax credits give you a refund only up to the amount you owe.
You will have to qualify for credits based on your filing status, adjusted gross income (AGI), family and dependents, home ownership, health care costs and education costs.
Common tax credits include child and dependent care credit, credit for the elderly or disabled, residential energy efficiency credit, foreign tax credit, education credit, etc.
Click here for the full list of credits allowed by the IRS.
Tax credits are made available by the government to incentivize “good” behavior such as making energy saving improvements to your home.
What is a tax deduction?
A tax deduction is the amount subtracted from your income BEFORE you calculate the amount you owe. It essentially reduces how much of your income is subject to taxes. The lower your taxable income, the lower your tax bill.
Deductions are usually entered in line 8 on IRS 1040 (filing personal taxes).
For example, if your adjusted gross income is $50,000 and you take the standard deduction of $12,000 as a single individual, then your taxable income is $38,000.
For many of our clients, we encourage clients to take advantage of pre-tax retirement savings accounts such as 401(k)s and IRAs. It helps lower their taxable income plus further reduces it by standard or itemized deductions.
You can either take the Standard Deduction or Itemized Deduction, whichever is greater.
Standard tax deductions are calculated based on your filing status. In 2021, if you’re filing single, the Standard Deduction is $12,550 and if you file as married jointly, it is $25,100. You do not have to qualify or provide documentation to take a Standard Deduction.
Itemized Deductions are line-by-line deductions that may include items such as charitable donations, home mortgage interest, medical expenses, etc.
THE BOTTOM LINE:
Tax credits and deductions both help lower your tax bill, but they work in different ways. Every tax filer gets the Standard Deduction, but if you can get tax credits on top of that, even better!
If you have a lot of deductions that may exceed the Standard Deduction, it may be best to Itemize. Tax credits lower your tax bill dollar-for-dollar, but you must qualify.
Consult your tax professional to make sure you’re taking advantage of all credits and deductions available based on your situation.