Tax Credit vs. Deduction: What Are The Differences?

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Are you tired of the never-ending cycle of taxes? Whether you’re an employee trying to make ends meet or a small business owner looking for ways to reduce your tax burden, taxes can feel like a constant drain on your finances.

But understanding tax credits and deductions can make a world of difference in the amount you owe or the size of your refund. Various tax breaks are available to help you lower your tax bill and save money.

This blog post will provide examples of the difference between tax deductions and tax credits.

So grab a cup of coffee, sit back, and let’s dive in!

Key Takeaways

  • Tax credits are much more advantageous than deductions because they directly subtract from your tax liability.
  • Tax credits immediately reduce how much you owe in income taxes, dollar for dollar, while tax deductions reduce your taxable income and thus reduce the amount of taxes owed.

What are Tax Credits?

This tax credit is a dollar-for-dollar reduction in your tax bill. That means if you are eligible for, say, $1,000 in credits, that’s $1,000 less in taxes you’ll owe at the end of the year! There are two types of credits: non-refundable, refundable, and partially-refundable.

Non-refundable Credits

Non-refundable credits are credits that cannot exceed your tax liability. If you owe less than the amount of the credit, you will only receive a credit for the amount you owe. This tax credit can reduce your tax liability to zero but cannot result in a tax refund.

Most Common Non-refundable Credits:

  • Child and Dependent Care Credit: This credit is worth up to $3,000 per qualifying child or $6,000 for two or more qualifying persons if you meet the eligibility requirements for the tax year 2022
  • Lifetime Learning Credit (LLC): You can claim 20% of the first $10,000 in qualified tuition and related expenses for eligible students enrolled in an eligible educational institution. For more details, you can refer to LLC from IRS.
  • Retirement Savings Contributions Credit: This credit is for taxpayers who contribute to a retirement savings account such as a 401(k) or IRA

Refundable Credits

These credits can reduce your tax liability to zero, and any excess credit will be refunded as a tax refund. Refundable credits are generally more beneficial than non-refundable tax credits.

Example: Let’s say you owe $2,000 in taxes and have a refundable tax credit of $2,500. This credit will reduce your tax liability to zero, and you will receive a refund of $500.

Most Common Refundable Credits

  • Earned Income Tax Credit: This fully refundable tax credit is for low to moderate-income earners.
  • Premium Tax Credit: This credit helps you lower your monthly payment for individuals who purchase health insurance through the Health Insurance Marketplace.

Partially Refundable Credit

Partially refundable credits are a great way to receive a refund even if you didn’t owe any taxes for the year. They differ from nonrefundable credits, which can only reduce your tax liability to zero but won’t result in a refund.

However, partially refundable credits can only refund up to a certain percentage of the credit, with the rest being non-refundable.

American Opportunity Tax Credit (AOTC) is partially refundable and provides a credit for higher education expenses.

If this credit brings the amount of tax you owe to zero, 40% of any remaining amount of the credit (up to $1,000) can be refunded to you. The maximum annual credit is $2500 per eligible student

What are Tax Deductions?

Tax deductions can be subtracted from your taxable income, reducing the income subject to taxation. The amount of your tax deduction depends on your filing status and income tax bracket.

These deductions include two types: standard deduction and itemized deduction.

Standard Deduction

The standard deduction is a fixed amount that reduces your taxable income based on your filing status.

For the tax year 2022, the average tax deduction amounts are:

  • Single filers: $12,950
  • Married filing jointly: $25,900
  • Head of household: $19,400
  • Married filing separately: $12,950

The additional standard deduction amounts for taxpayers who are 65 and older or blind are:

  • Single or Head of Household: $1.750
  • Married taxpayers or Qualifying Widow(er): $1.400

Taxpayers who do not have enough eligible expenses to itemize their tax deductions can take this deduction instead.


Itemized Deduction

Itemized deductions are eligible expenses that can be deducted from your taxable income instead of the standard deduction. You must use Schedule A to determine itemized deductions to claim these deductions.

On line 17 of Schedule A, you enter the total number. In case of your standard deduction number is bigger than the standard deduction one, you enter the full number on line 12 of form 1040.

Some itemized deductions include:

  • Mortgage interest
  • State and local taxes (up to $10,000 for 2022)
  • Gifts to charity
  • Medical and dental expenses (over 7.5% of your Adjusted Gross Income)
  • Student loan interest deduction
  • Interest paid
  • Casualty and theft losses

What is the difference between tax deductions and credits?

Tax deductions and credits similarly aim to reduce your tax bill, but they work differently. A tax credit directly reduces the amount of tax you owe, dollar-for-dollar.

So, if you owe $2,000 in taxes and have a tax credit of $500, your tax bill will be reduced to $1,500.

On the other hand, the tax deduction lowers the amount of your taxable income.

If you earn $50,000 and have $10,000 in tax deductions, your taxable income drops to $40,000. This, in turn, reduces the amount of tax you owe.

Final Thoughts

In conclusion, tax credits and deductions are powerful tools that can help reduce your tax bill and increase your tax refund.

Understanding the differences between these credits allows you to make informed decisions and take advantage of all available tax breaks.

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Frequently Asked Questions

What is a tax deduction example?

A tax deduction example would be if you made a charitable donation of $1,000 and itemized your deductions; you can deduct that $1,000 from your taxable income.

What is standard deduction vs. itemized?

The standard deduction is a fixed amount that reduces your taxable income based on your filing status. Itemized deductions are eligible expenses that can be deducted from your taxable income instead of this deduction. Taxpayers should itemize their deductions if their qualified expenses exceed the standard deduction amount.

Can a tax credit be refunded?

A refundable tax credit can reduce your tax liability to zero, and any remaining credit can be refunded. On the other hand, you can only use the non-refundable tax credit to reduce your tax liability to zero, and any remaining credit cannot be refunded.

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