13 Feb Tax Deductions versus Tax Credits: How Are They Different and Which Should You Take?
When filing your taxes, it’s important to take advantage of every deduction and credit you may qualify for. This is the best way to reduce the amount you owe in taxes, and possibly maximize your tax refund. But if you’re offered the choice between a tax deduction and a tax credit, how do you know which one to take? What are the differences and which one will offer the most benefit on your tax return? Here’s what you need to know.
A tax deduction allows you to reduce the total taxable income that you report on your tax return. So, if your taxable income is $50,000 and you discover that you qualify for an additional $1,000 tax deduction, you would then only be taxed on $49,000 of income for the year.
The direct benefit to you of a tax deduction (aka, the amount of money this puts back in your pocket) will depend on your tax bracket. You can calculate the total benefit by multiplying the deduction amount by your tax rate. For example, if you’re currently taxed at 32%, a $1,000 tax deduction would essentially put $320 back in your bank account.
Types of Tax Deductions
Every household qualifies to take either a standard deduction or to itemize their deductions each year. For 2018, the standard deduction amounts are as follows:
- Individuals, or married couples filing separately – $12,000
- Heads of household – $18,00
- Married couples filing jointly – $24,000
These numbers can be slightly higher for the elderly or disabled. If you have a large number of various deductions, and believe their value exceeds that of the standard deduction, you can choose to itemize your deductions on your tax return instead. This is often the route that self-employed individuals take, because they can write off many business-related expenses as itemized deductions.
Another common type of tax deduction is for medical expenses. If your total medical expenses for the year exceed 7.5% of your adjusted gross income, you qualify to write off the expenses as a tax deduction. You can also deduct charitable contributions, mortgage interest, state income tax, and property tax.
Rather than reducing your taxable income like a tax deduction, tax credits reduce your tax liability, or the total amount you owe in taxes. If you qualify to receive a $1,000 tax credit, your tax bill will be reduced by that amount; that means the back-in-your-pocket benefit of that tax credit is $1,000. Compare that to the $1,000 tax deduction mentioned above, which only offers you a percentage of the credit as actual money in your pocket.
Types of Tax Credits
There are two general types of tax credits—refundable and nonrefundable. Nonrefundable tax credits reduce your tax bill, but any excess amount will not be paid back to you. So, if you owe $800 in taxes, but qualify for a $1,000 nonrefundable tax credit, your total tax bill will be reduced to zero. However, you won’t get that extra $200.
Refundable tax credits, on the other hand, allow you to get the excess amount paid directly back to you. So, in the example above, if the tax credit were refundable, you’d receive a $200 check from the IRS. The most common refundable tax credit is the earned income tax credit (EITC). To qualify for this credit, you need to fall below a certain income level, which is based on your filing status and number of dependent children.
There are many different types of tax credits, which are offered for a variety of life-changing circumstances, such as:
- Having a child
- Adopting a child
- Enrolling in higher education
- Caring for an elderly parent
- And more
If you meet with one of our Provo tax preparers, we’ll ask you a series of questions to ensure that we get you every tax credit you qualify for, based on your current life circumstances.
So, to answer the question presented at the beginning of this article, if you must make a choice between a $1,000 tax credit and a $1,000 tax deduction, the tax credit will offer you a larger benefit than the deduction in most circumstances.
If you have any questions about tax credits and deductions, and which ones you might qualify for, be sure to reach out to our Provo tax preparers and we’ll work to get you every credit and deduction we can.