Tax deductions and tax credits reduce the amount you owe the IRS, but in different ways.
- Tax credit: A tax credit gives you a dollar for dollar reduction on your tax bill. For example, if your federal tax bill is $ 10,000 and you qualify for a tax credit of $ 2,500, that credit reduces your tax bill by $ 2,500 – to $ 7,500. Tax credits are incentives that governments give for behaviors they want to encourage, such as installing solar panels, buying an electric vehicle, or adopting a child.
- Tax deduction: A tax deduction reduces the amount of your income that is taxed. An example is the standard deduction, available to all taxpayers. The amount of the standard deduction may change each year and also depends on your filing status. If you decide to itemize your deductions instead of going for the standard deduction, you can deduct things like qualifying medical expenses assuming you also meet the required dollar amount limits.
Types of tax credits
There are three types of tax credits:
- Non refundable.
- Partially refundable.
Refundable tax credits
Refundable credits are treated as if they were tax payments you made throughout the year, just like money an employer withholds from your paycheck and sends to the IRS in your name.
If a refundable credit is more than your total tax liability, the IRS will send you the difference as a tax refund.
Some refundable tax credits include:
- Earned Income Tax Credit (ranges from $ 1,502 to $ 6,728, depending on the number of eligible children, and is fully refundable for 2021).
- Child tax credit (maximum $ 3,000 per eligible child aged 6 and over and $ 3,600 for children under six, and fully refundable for 2021).
- American Opportunity Tax Credit (maximum of $ 2,500 per qualified student, refundable at 40% of the remaining amount or up to $ 1,000 for 2021).
Non-refundable tax credits
If a tax credit is more than your actual tax bill but the credit is non-refundable, you don’t get the difference in the form of a tax refund. For example, if you owe $ 1,500 in taxes and qualify for a $ 2,000 credit, the credit reduces your tax bill to zero, but you do not get a refund for the remaining $ 500 of your credit. tax.
Some non-refundable tax credits include:
- Adoption tax credit.
- Tax credit for the elderly and disabled.
- Lifetime learning credit.
Partially refundable tax credits
A partially refundable tax credit can be used to reduce your tax bill to zero and from there you may be eligible for a refund on some of the remaining credit.
For example, the U.S. Opportunity Tax Credit, designed to help families pay for higher education expenses, is worth up to $ 2,500 if you are an eligible student or have a dependent dependent. qualifies as an eligible student. If the tax credit is more than the taxes you owe, 40% of the remaining amount (up to $ 1,000) can be issued as a refund.
Example: tax credit vs tax deduction
|Adjusted gross income (AGI)||$ 80,000||$ 80,000|
|Less tax deduction||($ 5,000)|
|Taxable income||$ 75,000||$ 80,000|
(married filing spouse)
|Calculated tax||$ 9,000||$ 9,600|
|Less tax credit||($ 5,000)|
|Total tax bill||$ 9,000||$ 4,600|
Tax credit or tax deduction: which is better?
Any legitimate deduction or credit that will lower your tax bill is a good thing. But tax credits outweigh tax deductions because of the amount of money they can save you, financial experts say.
âCredits win every time because they represent a dollar-for-dollar reduction in your tax bill,â says Megan Brinsfield, CPA and director of financial planning at Motley Fool Wealth Management. âDeductions will reduce your overall income before they apply to your tax rate. “
Deborah Todd, CPA and President and CEO of iCompass Compliance Solutions, agrees that credits are a more valuable way to lower your taxes. âWhile any tax deduction is better than no deduction, a tax credit will put more real money in your pocket,â she says.
The amount you save from a tax deduction will largely depend on your federal tax bracket. âDeductions reduce what you report as income; the dollar value you receive depends on your tax rates, âsays Justin Pritchard, chartered financial planner and founder of Approach Financial Inc., based in Montrose, Colorado.
Deductions reduce your taxable income by the percentage of your highest tax bracket. For example, if you are in the 24% tax bracket, a $ 1,000 deduction will save you $ 240 (1,000 x 0.24 = 240) on your tax bill.
With deductions, you can either take the standard deduction or itemize, but you cannot do both. If itemized expenses, such as medical bills, mortgage interest, and charitable donations, are higher than your standard deduction, you’ll save more money by itemizing them.
If you detail your deductions, take the time to make sure you don’t forget anything. Property taxes are important and can have a huge impact on lowering your tax bill. However, a deduction like this can easily be overlooked as there is no dedicated tax form that a county or government is required to send to you.