Tax Credits and Tax Deductions: What’s the Difference?
Tax Credits and Tax Deductions: What’s the Difference?
If you want to end up owing less money to the IRS after filing your taxes (and who doesn’t?), claiming tax credits and deductions can greatly help to shrink that number. However, because they work in different ways, understanding the difference between a tax credit and a tax deductible is crucial in scoring as many tax breaks as possible.
Tax Credits
Tax credits reduce the amount of taxes you owe, dollar for dollar, and regardless of tax rate. For instance, if you have a $100 tax credit, you will save $100 in taxes. Whether you qualify for a specific tax credit is based on several factors, including income, age, and tax filing status. Common tax credits include:
- Earned Income Tax Credit (EIC or EITC)
- Child Tax Credit
- Child and Dependent Care Credit
- American Opportunity Tax Credit
- Lifetime Learning Credit
- Adoption Credit
- Saver’s Credit
- Residential Energy Tax Credit
Refundable and Non-Refundable Tax Credits
A refundable tax credit will eliminate your tax debt and also refund you the difference. For example, if you owe $1,000 after completing your tax return but claim a $2,000 tax credit, $1,000 of the credit would go toward paying your debt to the IRS, and the remaining $1,000 would be returned to you.
A non-refundable tax credit, on the other hand, can decrease or even delete any tax you might owe the IRS, but any credit that’s leftover won’t be refunded to you.
Tax Deductions
Tax deductions reduce your taxable income, but there are two ways to claim deductions: itemized deductions and above-the-line deductions.
Itemized Deductions
Itemized deductions are a list of individual expenses that you have tracked throughout the year, keeping good records and supporting documentation along the way—receipts, bank statements, check stubs, insurance bills, etc. These are expenses that are eligible for write-offs on your return. Itemizing is generally the way to go if your total deductible expenses are greater than the standard deduction.
Common itemized deductions include:
- Medical expenses
- State and local income taxes
- Property taxes
- Mortgage interest
- Charitable contributions
The standard deduction is a fixed amount that varies according to your filing status. It is also tied to inflation, so the amount changes a bit each year. For 2019 returns, the standard deduction is:
- $12,200 for single filers and married filers filing separately
- $24,400 for married filers filing jointly
- $18,350 for heads of household
Above-the-Line Deductions
When claiming a standard tax deduction, you can use above-the-line deductions to reduce your adjusted gross income (AGI), thereby helping to lower you tax bill. Some of these deductions are:
- Health savings account (HSA) contributions
- Deductible contributions to IRAs
- The deductible portion of self-employment taxes
- Contributions to self-employed SEP-IRA, SIMPLE IRA, and other qualified plans
- Self-employment health insurance premiums
- Penalties on early savings withdrawals
Tax credits are generally more valuable than tax deductions, but above-the-line deductions can cut your tax liability and qualify you for other tax breaks based on income limits.
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