With tax credits and tax deductions, it’s sometimes confusing what the difference is and which will provide the lower liability.
In this guide, we’ll walk you through tax credits and tax deductions, showing you the differences and how you can use them to your advantage to lower your tax liability.
What is a Tax Credit?
A tax credit directly lowers the taxes you owe, dollar-for-dollar, after you have calculated what you owe. For example, if you have a $500 tax credit, the amount you owe (your tax liability) decreases by $500. A $500 tax credit for you is the same $500 tax credit for your neighbor. It directly lowers your liability without any complicated calculations based on your tax bracket or tax rate.
Tax credits reward taxpayers for certain things, such as:
- Working – Earned Income Tax Credit
- Going to college – American Opportunity Tax Credit or Lifetime Learning Credit
- Paying for daycare or adult care – Child and Dependent Care Credit
- Saving for retirement – Savers Tax Credit
- Adopting a child – Adoption Credit
- Going green – Residential Renewal Energy Tax Credit
There are two types of tax credits:
- Refundable – If the tax credit exceeds your tax liability, you receive a refund for the difference
- Non-refundable – If the tax credit exceeds your liability, you don’t receive a refund for the difference. You can zero out your liability, but you don’t get the remainder of the credit.
For example, if your tax liability is $1,000 and you have a $1,500 credit, the type of credit you have will determine if you get the difference. With a refundable credit, you’d receive the $500 as a tax refund. If the credit is non-refundable, you’d only claim $1,000 of the credit, zeroing out your tax liability.
How a Tax Credit Works
Let’s look at an example of a few income tax credits.
- Earned Income Tax Credit – This credit is for filers with ‘low income.’ It helps offset the Social Security tax you pay. The IRS has income limitations for single filers with and without children and married filing joint filers with and without children. If your adjusted gross income is less than the limits, you may qualify for a credit between $529 - $6,557.
- Child Tax Credit – If you claim a child (your child) on your taxes, you automatically get a child tax credit of $2,000 per child and up to $1,400 of it is refundable. The credit exists for all children 16 and under that live with you.
- Residential Renewal Energy Tax Credit – Equipping your home with energy-efficient equipment may result in a 30% of the cost credit. There’s no limit on the credit for solar, wind or geothermal energy-efficient changes. Fuel cell energy-efficient changes have a maximum credit of $500 per half kilowatt or $100 per full kilowatt.
- Child and Dependent Care Credit – If you pay for childcare, you may receive a credit of 20% - 35% of your child care costs. The exact amount you receive depends on your total income. The credit is on the first $3,000 in childcare expenses for one child or up to $6,000 for multiple children.
What is a Tax Deduction?
Unlike a tax credit, a tax deduction lowers your taxable income. It’s not a direct credit on your tax liability; rather, it decreases your income so that you pay less. It doesn’t have the same ‘grand gesture’ that a tax credit has, but every dollar counts.
Tax deductions lower your income, which may or may not lower your tax bracket. That’s what it all comes down to. The tax brackets determine how much you owe. Obviously, the more money that you make, the higher the tax bracket you belong to.
When you file your taxes, you have two options for deductions:
- Standard deduction - Single filers $12,400 and married filing joint filers $24,800
- Itemized deductions - You complete Schedule A with all of the deductions you qualify for
The Tax Cuts and Jobs Act greatly increased the standard deduction, making it harder for many to qualify for itemized deductions. However, this is a good thing as the standard deduction is available to every taxpayer.
Common Itemized Deductions
If you think you qualify for itemized deductions, consider the following:
- Mortgage interest
- Property, local, and state taxes
- Charitable donations
- Medical expenses
- IRA/401K contributions
- Home office deduction
- Mileage deduction
- Educator expenses deduction
Each tax deduction has limitations, for example, the mortgage interest deduction allows you to deduct interest paid on up to the first $750,000 in mortgages on your primary or secondary home. The property tax deduction allows you to deduct a percentage of the first $10,000 you pay in property taxes. Total up your itemized deductions to see if they are more than the standard deduction. If not, taking the standard deduction will lower your tax liability the most and get you off the hook of having to provide documentation to prove the deduction.
Always ensure that you maximize your tax credits and deductions. They aren’t mutually exclusive. You can take all of the tax credits and deductions that pertain to your situation. Just make sure that you have the documentation to prove that you are eligible for the credits and deductions as you’ll need to provide ample proof. The tax credits and deductions help minimize your tax liability.