We’ve all heard of tax credits and tax deductions. And we know that tax credits and tax deductions are good things. And that they can save you money come tax time. But have you ever considered how they work? And if there’s a difference between them? In this post, we’ll take a closer look at these credits and deductions and explain how they work with examples.
What’s a Tax Credit?
A tax credit is an amount that’s subtracted from your tax liability. leaving you the total tax you owe for the tax year. Tax credits give you a dollar-for-dollar reduction in your tax liability. Say, for example, you owe $1,000 in taxes and you have a $600 tax credit. Your liability would go down by $600, making your total tax liability $400.
Tax credits can be very valuable, so knowing whether or not you qualify for one is advantageous. Here are some common tax credits (this information is up to date as of 2020):
Child Tax Credit:
This is a very common tax credit that depends on your income to determine what you qualify for, You can get a credit of up to $2,000 per child and up to $500 for any non-child dependents.
Child and Dependent Care Credit:
If you pay for child care or dependent care, you may qualify for the child and dependent care credit. This credit can range from 20% to 35% of up to $3,000 in care expenses for a single child or dependent or 20% to 35% of up to $6,000 for two or more dependents. Why the range? The percentage you can claim as your credit depends on your income.
Earned Income Credit:
The earned income credit is a benefit for working people who have low to moderate income. For those with a qualifying child and an AGI of around $55,000 or less, this credit can be a big help at tax time. For these taxpayers, this credit can range from $3,461 to $6,431, depending on marital status, income, and how many children they have. Lower-income taxpayers can also qualify for this credit. Even if they don’t have children. Those who make less than $15,270 as a single filer or $20,950 filing jointly can get up to $519.
The Saver’s Credit:
This is a credit that allows you to deduct money put into retirement savings accounts. Qualifying taxpayers can deduct 10% to 50% of up to $2,000 (or up to $4,000 for joint filers) contributed to certain types of savings accounts. This is a must for tax planning which you can learn more about here.
Other common tax credits include:
- The adoption credit
- The American Opportunity credit,
- The Lifetime Learning credit,
- The residential energy tax credit
- the plug-in electric motor vehicle credit.
What’s a Tax Deduction?
A tax deduction is an amount that’s subtracted from your total taxable income, which is the part of your income that’s subject to tax. For your tax deductions, you can either take the standard deduction or do itemized deductions. To give an example of how tax deductions work, let’s consider the standard deduction for single filers, which was $12,000 last filing year. If you made $45,000 in 2018, you could have taken the standard deduction of $12,000, making your taxable income $33,000.
The standard deduction is a set deduction amount that almost everyone qualifies to take. For this past filing season, the standard deduction for single filers was $12,000. For those married filing jointly, it was $24,000.
Those who qualify for the standard deduction (which, again, is almost everyone) have a choice: Either take the standard deduction amount or opt for itemizing their deductions if that amount is higher.
Itemized deductions work like standard deductions to reduce your taxable income. However, you have to list them individually on your tax return and you must have a total itemized deduction amount that is higher than your available standard deduction amount to take your itemized deduction amount.
Tax Credits and Tax Deductions
Here are the current National Standards as outlined by the IRS.
If your itemized deductions added up to $13,000 and you qualify for the $12,000 standard deduction for single filers, you could (and should) take your itemized deduction amount instead, which would reduce your taxable income by $1,000 more than the standard deduction.
There are many, many itemized deductions one can take. Some examples of common itemized deductions include state income taxes, property taxes, charitable contributions, mortgage interest, certain medical expenses that exceed a certain percentage of your AGI, and the home office deduction.
How are Tax Credits and Tax Deductions Different? Is One Better?
It’s easy to confuse tax credits and tax deductions, since they can both help you save money when you file your taxes, but they are quite different. Additionally, if you were able to pick between the two (assuming the credit or deduction dollar amount was the same), you would want to choose a tax credit.
Tax credits give you a dollar-for-dollar credit off your tax liability, while tax deductions reduce your taxable income. A $300 tax credit would reduce your owed taxes by $300. On the other hand, a $300 tax deduction would reduce your taxable income by $300, which would affect how much tax you owe, yet by a much smaller margin.
Of course, you want to claim all the credits and deductions that you’re legally able to. But know that, generally, credits tend to be very valuable and should not be missed.