Posted by KLSM CPA Firm PLLC

Tax Credits vs. Tax Deductions

Tax Credits vs. Tax Deductions

There are several ways to reduce the tax burden. However, the two most popular are probably tax credits and tax deductions. While they may look the same, they are two very different mechanisms. A tax credit allows for a dollar-for-dollar reduction in taxes owed, while a tax deduction reduces taxable income for that year. However, both can save you money. For help with all tax matters, consider working with a financial advisor.


Tax credits: the basics

Tax credits reduce the amount of tax owed dollar for dollar. For example, if you are eligible for a tax credit of $1,500 and have a debt of $3,000, the credit will reduce your tax debt by $ 1,500. Your ability to claim a specific tax credit depends on several factors, including your income, age, and status.

While the claim for tax credits may result in a higher repayment, some loans are non-repayable. This means that if your credit reduces your tax debt to a negative number, what is left cannot be used to increase your tax refund. For example, if you have a $ 1,500 tax credit but owe only $ 1,400 in taxes, the additional $ 100 will not be included in your refund check.

A refundable tax credit can help you increase your tax refund. The earned income tax credit is refundable. There are also partially refundable tax credits, such as the U.S. Opportunity Tax Credit. With these types of tax exemptions, part of the credit is refundable, and part is non-refundable.

Here is a list of other common tax credits:

  • Adoption credit (for adoption costs)

  • Child and dependent care credit (designed to offset the costs of child care or elderly parents)

  • CTC (for parents of dependent children)

  • Credit for lifetime learning (for higher education expenditure)

  • Premium tax credit (for individuals who purchased health insurance in the federal marketplace)

  • Saver's credit (for people who have contributed to a tax-advantaged retirement account)


Tax deductions: basic elements

Tax deductions reduce taxable income for the tax year. There are two methods to claim deductions. One is to claim the standard deduction. This is the type of deduction that any taxpayer can automatically claim. Your filing status determines the amount you can deduct. The higher standard deduction is reserved for couples who file a joint tax return.

If you don't plan on taking the standard deduction, you can itemize the deductions. Itemizing deductions involves listing out specific expenses that you plan to write off on your return. Itemizing your deductions usually makes more sense if the total deductible expenses are greater than the standard deduction.

Here are some instances of deductible expenses for fiscal 2017. While some of them need to be Itemized, others (like the deduction of interest on student loans) are above the line deductions. You can claim deductions above the line as separate deductions, even if you don't itemize them.

  • Charitable donations

  • Contributions to a traditional IRA

  • Contributions to health savings accounts (HSA)

  • Job search costs

  • Land and property taxes

  • Medical and dental expenses

  • Mileage for business trips

  • Mortgage loan interest

  • Moving expenses to start a new job

  • Teacher educational expenses

  • Tuition and fees

  • Unreimbursed business expenses 

Please note that your ability to claim certain deductions may be limited, depending on your filing status and family income status. Another thing to keep in mind is that you cannot claim credit and deduct the same qualifying expense. If you were paying out of pocket to go back to school and get a degree, for example, you wouldn't be able to claim tuition fees and a tuition deduction, and lifetime learning credit.


Tax credit vs. tax deduction: which is better?

Tax credits are commonly regarded as better than tax deductions because they directly reduce the amount of tax owed. Your marginal tax bracket determines the influence of a tax deduction on your tax liability. For example, if you are in the 10% tax bracket, a deduction of $ 1,000 will reduce your taxable income by only $ 100 ($ 0.10 x $ 1,000 = $ 100).

However, if you are eligible for a tax credit and deduct the same expenses, doing some calculation can help you determine which one will provide the most tax benefits.


Bottom Line

Tax credits and tax deductions help to reduce the amount you pay in taxes, but they do so in different ways. A tax credit is a dollar-for-dollar reduction in the money you owe, while a tax deduction will reduce your taxable income, resulting in a slightly lower tax bill.


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