Tax credits and deductions both work to lower your tax liability, but they do so in different ways! How? Let’s break it down for you!
Tax credits and deductions both work to lower your tax liability, but they do so in different ways!
Tax deductions lower your taxable income, potentially lowering the amount of taxes you'll owe, whereas tax credits lessen your tax liability dollar for dollar and might even boost your refund.
Tax credits directly reduce the amount of taxes you owe on a dollar-for-dollar basis. If you qualify for a $3,000 tax credit, for example, you will save $3,000 on your tax bill. In some cases, a tax credit might result not just in a lower tax payment but also in a tax refund.
For example, if you qualify for a $1,000 completely refundable tax credit and only owe $700 in taxes, you will receive a tax refund for the $300 credit that exceeds your tax payment. However, not all tax credits are refundable. A nonrefundable tax credit can lower your tax bill to zero, but if the credit is worth more than you owe on your tax bill, the IRS will not send you a check for the difference.
- American Opportunity Tax Credit: The American Opportunity Tax Credit is a partially refundable credit that helps pay for the first four years of college. Students who are eligible and whose parents claim them as a dependent can get a $2,500 credit per year. If the credit lowers a tax bill to zero, 40% of any credit left over, up to $1,000, can be given back as a tax refund.
- Earned income tax credit: The earned income tax credit is a refundable tax credit that can help those with low to moderate incomes lower their tax bill. The value of the credit depends on whether or not you are disabled or have children or other dependents. Whether or not you can get the earned income tax credit also depends on how you file your taxes and how many people are in your family.
- Saver's Credit: Taxpayers who qualify can get a nonrefundable tax credit for certain contributions to employer-sponsored retirement plans or individual retirement accounts. If you qualify, your Saver's Credit can range from 10% to 50% of your contributions, depending on how much you put in and how much money you make.
A tax deduction lowers your taxable income, which, in turn, lowers your tax bill. Unlike a tax credit, a deduction doesn't lower your tax bill dollar for dollar. Instead, how much a deduction lowers your tax bill depends on where you are in the income tax bracket.
Your income tax bracket determines how much tax you pay on different parts of your income. Since the marginal tax system makes tax rates go up as income goes up, deductions can help people with higher incomes save more money.
If you file your taxes as a single person and your highest tax rate is 35%, a $2,000 tax deduction could save you $700. If, on the other hand, your highest tax bracket is 22%, the same tax deduction could save you $440. All tax filers have the option of selecting either the standard deduction, which lowers their taxable income by a certain amount, or itemizing their tax deductions and taking out specific expenses that are tax-deductible from their tax base.
In 2022, the standard deduction for a single filer is $12,950 and for a married couple filing jointly it is $25,900. There is no limit on how much you can deduct for each item, but there are limits on how much you can deduct for certain types of expenses. Usually, people with higher incomes benefit more from itemizing than from taking the standard deduction.
To decide if you should take the standard deduction or itemize your deductions, you'll need to compare the amount of itemized deductions you're allowed to take with the amount of your standard deduction. Then choose the one that lowers your taxable income the most.
- Educator expenses deduction: Teachers who qualify can deduct up to $250 in qualified expenses like school supplies, materials, equipment, books, and professional development courses. This deduction is available to teachers whether or not they itemize their deductions or take the standard deduction.
- Home office deduction: If you only use your home office for business, you can use the home office deduction to write off a portion of your rent and property taxes, based on how much space the office takes up.
- Deduction for medical and dental costs: Some taxpayers may be able to deduct medical and dental costs for themselves, their spouse, and their dependents. The deduction depends on how much money you make, and it only applies to certain qualified medical expenses.
- State and local tax deduction: With the state and local tax deduction, qualified taxpayers may be able to deduct up to $10,000 of state and local taxes they paid in the current tax year.
In the event that all other factors are equal, a tax credit will reduce your tax bill more than a tax deduction for the same amount. This is because a tax credit reduces your taxes dollar for dollar, while a tax deduction lowers the amount of income you pay taxes on. Consider the difference between a $1,000 tax credit and a $1,000 tax deduction. It's easy to figure out how much money a tax credit saves you: If you are eligible for a $1,000 tax credit, your tax bill will go down by $1,000.
To figure out how much money a deduction saves you, you have to do a little more math. If you qualify for a $1,000 tax deduction, $1,000 will be taken off of your taxable income. The cut will change how much of your income is taxed in your highest tax bracket. For example, if your highest tax bracket is 15% and your income is $1,000, this deduction will save you $150 in taxes (15% of $1,000). Even if you were in the highest tax bracket, which is 37%, a $1,000 deduction would only give you $370 back, which is much less than a $1,000 credit.
- You can lower your tax bill in two ways: with tax credits and tax deductions.
- You can save more money if you know how credits and deductions work and how they are different.
Remember that taking the standard deduction can help you lower your tax bill even if you don't qualify for any other specific deductions. It does this by lowering your taxable income by a certain dollar amount. On the other hand, some taxpayers can save more money if they itemize.
For business tax planning articles, our tax resources provides valuable insights into how you can reduce your tax liability now, and in the future.
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