Tax credits vs tax deductions: What is the difference? And which one should you focus on?
Now, of course, no one really wants to pay more than their fair share of taxes.
And understanding the difference between tax deductions and tax credits can give you more confidence that you are not paying too much in taxes.
So, we would guess that you probably know that claiming a tax deduction or tax credit can help reduce your taxable income.
This is especially awesome if you made a lot of money and don’t want to owe the IRS.
But in this post, we want to explain the differences between tax credits vs tax deductions so you can spend your time wisely!
Now as tax preparers for many years, finding tax credits and tax deductions for our clients is one of the most satisfying parts of preparing a tax return.
This is because we were able to literally help save people hundreds and thousands of dollars.
So we are excited to share with you all the ins and outs today.
Let’s start off with some of the basics and then get a little bit deeper with examples.
What is a Tax Credit?
A tax credit directly reduces the amount of tax you owe, by giving you a “dollar for dollar” reduction of your tax liability.
For example, if you owe $2,000 in taxes and then get a $2,000 credit then your tax liability becomes zero. AKA you won’t pay anything in taxes!
What is a Tax Deduction?
So a tax deduction reduces how much of your income is subject to taxes.
The tax deduction focuses on lowering your taxable income NOT your tax liability.
Your taxable income is going to be based on how much money you made and the tax bracket you fall into.
So, if you are in the 24% 2021 tax bracket and then a $2,000 deduction saves you $480 on your tax liability (which is $2,000 x 24%).
Now immediately, just based on that example alone, you probably noticed that tax credits give much more savings than tax deductions.
We mean you have a $2,000 savings vs $480 savings.
BUT, that’s not always the case.
Are Tax Credits Better than Deductions?
Let’s look at the “catch” when it comes to tax credits.
So, some tax credits are nonrefundable. And that basically means that if you don’t owe a lot in taxes, you may not get the full value of the credit.
Say, for example, you owe $500 and get a $2,000 tax credit.
Well because you only owe $500, your tax credit is basically reduced to $500 and you don’t get a refund. Hence, “nonrefundable”
However, there are some tax credits where you can get a refund.
The popular ones that you probably are aware of are the:
- Earned Income Tax Credit
- Child Tax Credit
These two credits will allow you to wipe out your tax liability AND get a refund check from the IRS.
However, there are specific requirements from the IRS that you must meet to qualify for nonrefundable and refundable tax credits.
On the other hand, some deductions like depreciation and other losses can sometimes carry forward and be applied to another tax year.
Thus, giving you a little bit more savings.
Tax Standard Deductions
Now, remember, we want you to spend your time focusing on the right things.
So here’s the big thing, everyone in the U.S. gets what is called a “standard deduction.”
And we’ve seen countless amount of times when clients have to experience the hassle of going through all their bills, paperwork, and other expenses.
Only to find out that their expenses do not exceed their standard deduction amount.
So here are the standard deduction amounts for the 2020 tax year and 2021 tax year categorize by filing status.
As you can see, if you are single then you automatically are given $12,400 as a standard deduction.
This means if you don’t have more than $12,400 in tax deductions then you aren’t getting any benefit by adding them.
And the standard deduction gets even higher at $24,800 if you are married.
So clearly, you will need a lot of qualified deductions in order to make good use of deductions for your personal tax return.
Example of Tax Credits vs Tax Deductions
Let’s bring all this together and look at an example comparing tax credits vs tax deductions.
In this example, let’s look at which one you would rather have, a $10,000 tax deduction or a $10,000 tax credit?
Let’s say your adjusted gross income is $100,000. A tax deduction would reduce your taxable income to $90,000. And at a simple tax rate of 24%.
Your tax bill would be $21,600. ($90,000 x 24%).
On other hand, if you only have a tax credit, your taxable income would be $100,000 and you would owe $24,000 ($100,000 x 24%).
But your tax credit would reduce your tax bill by $10,000, so you would only owe $15,000.
In this example… the tax credit wins!
Would you rather have:
Which is Better? Tax Credits vs Tax Deductions?
So now, the big question is – which one is better? Tax credits or tax deductions?
Well, as you probably guessed by now… it depends.
If you have a high income and spend a lot of money on qualified tax items, then deductions will help you significantly more than tax credits.
That’s because tax credits are usually given to and more beneficial for low-income individuals. Plus there are not as many tax credits available as there are with deductions.
But of course, you should go for BOTH especially if you meet qualifications that allow you to get refundable tax credits and surpass the standard deduction amount.
Well, we hope this post made sense. But if you have any questions regarding your specific tax situation, give us a call today.