Tax Credits and Tax Deductions
When it comes to tax preparation, the mere mention of tax credits and deductions will be music to any taxpayer’s ears. That’s because both tax credits and tax deductions are used to lower the amount of taxes someone owes the government. While they’re both worthy of excitement, it’s important you understand the fundamental difference between these two terms.
What Are Tax Credits?
Simply, tax credits are a reduction on the actual tax owed. Tax credits have no effect on your taxable income or your tax bracket. Think of these credits as reductions that come after the fact - i.e. after you have determined the amount you owe the government. There are some common types of tax credits that can be given based on your income level, whether or not you have children, if you’re a college student and more. These common credits include:
- Adoption Credit
- Child and Dependent Care Credit
- Child Tax Credit
- Earned Income Tax Credit
- Lifetime Learning Credit
- Residential Energy Tax Credit
Tax credits are usually either refundable or non-refundable. Which credit type it is will affect how much you’ll receive back in your tax refund.
REFUNDABLE TAX CREDITS
Refundable tax credits are tax credits that allow you to be refunded the remaining, unused portion of a credit. For example, say you owe $900 in taxes, but your eligible child tax credit is worth $2,000. Not only will this cover the $900 you owe in taxes, but you will also be refunded the remaining $1,100.
NON-REFUNDABLE TAX CREDITS
Alternatively, non-refundable tax credits will only cover the taxes you owe, up to the credit’s limit. If there is more in the credit amount than what you owe, you do not receive the excess amount in the form of a tax refund. For example, if you owe $900 in taxes and your tax credit is worth up to $2,000, the $900 will be covered but you will not receive the additional $1,100.
What Are Tax Deductions?
Tax deductions are used to reduce the amount of income that is eligible to be taxed. By reducing your taxable income, you may fall into a lower tax bracket, meaning you are subject to paying a lesser tax percentage. There are typically two different types of tax deductions: itemized deductions and above-the-line deductions.
ITEMIZED DEDUCTIONS
You can use itemized deductions to help lower your taxable income. Common types of itemized deductions include:
- Charitable donations
- Medical expenses
- Mortgage interest
- Property taxes
While people are welcome to include each deduction separately on their taxes (i.e. itemize them), most folks will opt for the standard deduction set by the IRS. For the 2022 income tax year, the standard deduction amounts are:
- Single or married but filing separately: $12,950
- Married and filing jointly or qualifying widow(er): $25,900
- Head of household: $19,4001
It’s very common to use a standard deduction because an itemized amount won’t usually exceed the IRS’s standard deduction rates.
ABOVE-THE-LINE DEDUCTIONS
Above-the-line deductions are used to reduce your adjusted gross income (AGI), which can qualify you for certain itemized deductions and tax credits. Your AGI is determined by subtracting above-the-line deductions from your gross income. The resulting AGI is lower which can then allow you to claim important tax credits or deductions that may be dependent on income level. Common above-the-line deductions include:
- Alimony paid
- Deductible IRA contributions
- Educator expenses
- Moving expenses of armed forces members
- Student loan interest
Tax credits and tax deductions can both greatly benefit taxpayers, especially when you are able to make them work in tandem. Familiarizing yourself with the difference between these two important tax terms gives you a great place to start understanding and researching what deductions and credits you and your spouse may be eligible for in the upcoming tax year.