You’re well within your rights to use every available legal avenue to reduce your tax bill. Tax credits and tax deductions are both powerful instruments for achieving this. However, many laypeople only have an incomplete or vague understanding of what they are and how they work. You’ll need to develop a deep understanding of these money-saving tools if you want to maximize the benefits they offer. To that end, here’s a primer on tax credits, tax deductions, how they work, and how they differ from one another.
What is a Tax Credit?
Tax credits deliver direct, dollar-for-dollar discounts on your tax bill. For example, suppose you’ve determined that you owe $4,000 in income tax before applying a $1,500 tax credit for which you are eligible. The tax credit will reduce your total bill by $1,500, leaving you liable for $2,500 instead of $4,000.
Different Types of Tax Credits
Tax credits fall into two main categories: refundable and non-refundable. Refundable credits deliver financial benefits even if you do not owe any income tax. They also provide savings if the value of the credit exceeds your tax liability.
For example, suppose you’ve determined that you owe $2,000 in income tax before factoring in a refundable tax credit worth $3,800. Not only would your $2,000 liability be erased, but you would also be entitled to an $1,800 refund to reflect the credit’s full value.
Non-refundable credits work a little differently. You can apply them to your tax liability but not anything beyond it. Using the same numbers as above, if you owed $2,000 in tax before utilizing a non-refundable $3,800 credit, your liability would be reduced to zero. However, you would not be entitled to the $1,800 refund. Any amount not utilized in the current tax year is forfeited. You may not claim it in future tax years.
Examples of Commonly Used Tax Credits
The following types of tax credits rank among those most commonly claimed by taxpayers.
- Earned Income Tax Credit (EITC) for lower-income households, primarily those with children.
- Child Tax Credit for low-to-moderate income families with children.
- American Opportunity Tax Credit for undergraduate students enrolled in higher education.
- Lifetime Learning Credit for postsecondary students at eligible institutions.
- Saver’s Credit for individuals with low-to-medium incomes who are working to put money away for retirement.
- Residential Energy Tax Credit for homeowners who have invested in green energy technologies and home comfort features.
You can learn more about tax credits and link to comprehensive lists of qualified refundable and non-refundable options through the American federal government.
What is a Tax Deduction?
Like tax credits, tax deductions reduce the amount you owe. However, they use a different mechanism for achieving those savings. Instead of directly lowering your tax bill on a dollar-in, dollar-out basis, deductions decrease the amount of taxable income subject to taxation.
The actual value of the deduction depends on which tax bracket you’re in. For example, if you made $90,000 in 2020, you’re in the 24% bracket. A $2,000 tax deduction would thus be processed at the 24% rate, reducing your taxable income to $88,000 and yielding $480 in actual tax savings. Here’s another way to look at it. Say you’ve determined that your taxable income for the year was $53,000, then discover you qualify for a $4,000 tax deduction. After applying the deduction, your taxable income would fall to $49,000.
Different Types of Tax Deductions
Like tax credits, tax deductions come in two main types. There are itemized deductions and above-the-line deductions. Itemized deductions are expenditures you can claim to reduce your taxable income. They include certain types of goods and services, as well as some types of expenses and charitable contributions. Itemized deductions are so named because they appear as individual line items on your tax return.
Above-the-line deductions differ in that they reduce your adjusted gross income (AGI), not your taxable income. AGI is used to determine whether you are eligible for some types of deductions and credits. Certain tax advantages are only available to people whose incomes fall within a specified range.
Examples of Commonly Used Tax Deductions
Some of the most widely claimed itemized tax deductions apply to purchases and expenses such as the following.
- Medical expenses: You can deduct most medical expenses from your taxable income, provided they apply to medically necessary services or treatments. However, certain rules, thresholds, and limits apply, so be careful.
- State and local income tax: If the city or state in which you live charges income tax beyond the tax you pay to the federal government, you are eligible to deduct those taxes from your federal taxable income, up to $10,000.
- Property taxes: If you own your home, you can treat the property taxes you pay as an itemized deduction.
- Interest on mortgage payments: While the mortgage payment itself is not tax-deductible, the interest portion is, within certain limits.
- Contributions to eligible charities: Make sure the charity you’re donating to is an entity which legally allows contributions to be made in a tax-deductible manner. Be sure to request a statement from them that accurately reflects the value of your financial gift.
Many other expenses qualify as itemized tax deductions. For a complete list, consult Schedule A of IRS Form 1040.
Meanwhile, above-the-line tax deductions include such expenses like these.
- Certain types of business expenditures, especially for self-employed individuals and contractors.
- Contributions to health savings accounts (HSAs).
- Health insurance premiums for self-employed persons.
- Interest on student loan payments.
- Some contributions to individual retirement accounts (IRAs).
Schedule 1 of IRS Form 1040 details the various above-the-line deductions available to taxpayers.
Maximize Your Credits and Deductions
Tax credits and tax deductions are both very useful ways to reduce your tax burden and increase your refund eligibility. However, they can be challenging for nonprofessionals to understand. In order to take full advantage of them, it’s a good idea to consult a reputable tax professional. If possible, choose a tax preparer who participates in the IRS’s enrolled agent program. Alternatively, use a licensed certified public accountant (CPA) or tax attorney.
The Last Word
There are also a few words of warning to keep in mind. First, some unscrupulous tax “professionals” tie their fees to the amount of tax credits, tax deductions, and tax returns they secure for their clients. It isn’t uncommon for such people to claim credits and deductions you aren’t legally eligible for so they can pad their own earnings. When that happens, you’ll be the one on the hook for any unauthorized credits or deductions they claim.
Secondly, you may be tempted to exaggerate our tax-deductible expenditures and credits in a bid to reduce your tax burden or milk some extra money from your return. This is also something you should avoid, as the IRS will discover your dishonesty if you get audited. This is considered a form of tax fraud and you can face serious penalties if you’re caught.