Tax Credits vs Tax Deductions
When it comes to filing taxes, credits and deductions are two fantastic ways to save money. However, you have to know how to use each mechanism properly in order to save money effectively. So, how do you use tax credits and tax deductions?
Tax credits are subtracted from your total taxes after your tax liability has been assessed making them effective in reducing your year-end tax bill. Tax deductions are more effective at reducing your liability by decreasing the amount of your income that is subject to taxes.
In this article, we will take a closer look at how tax credits and tax deductions work. Additionally, we will look at how to utilize tax credits and deductions to save you money.
How do Tax Deductions Work?
A tax deduction is applied before your tax liability is assessed and decreases the amount of your income that is subject to taxes. The deduction is applied to your adjusted gross income (AGI) and your taxes are then calculated off the new amount.
Let’s look at how this works in a real-life scenario:
Mike makes $75,000 a year prior to any deductions. If Mike’s tax rate is 22% he would owe $16,500 in taxes. That means his actual income would be $58,500.
Now let’s say Mike takes the standard 2022 deduction which is $12,950. He would subtract $12,950 from $75,000 before calculation his taxes. Therefore, he would only need to pay taxes on $62,050 of his income.
Even if Mike still was taxed at a 22% rate he would only pay $13,651 in taxes because of his deduction. That’s $2,849 in savings!
What is a Standard Deduction?
When filing your taxes you can either take the standard deduction or an itemized deduction.
A standard deduction is a pre-determined standard amount that the IRS permits everyone to take. You can claim it regardless of which deductions you actually qualify for because everyone qualifies for the standard deduction.
The deduction varies based on filing status:
|Married, filing jointly||$25,100||$25,900|
|Married, filing separately||$12,550||$12,950|
|Head of household||$18,800||$19,400|
What is an Itemized Deduction?
An itemized deduction is when you claim individual tax deductions on expenses based on what the IRS considers a deduction. In order to take an itemized deduction, you’ll need to keep track of your expenses throughout the entire year. This can be burdensome, but it can also save you a lot of money.
Can I Claim a Standard Deduction and an Itemized Deduction?
You are only able to claim a standard deduction or an itemized deduction. You are unable to file a combination of the two.
Additionally, if you are married filing separately, both you and your spouse need to either file a standard deduction or an itemized deduction. One of you cannot file an itemized deduction, while the other files an itemized deduction.
How Do Tax Credits Work?
A tax credit is applied after the tax liability on your income has been assessed. In other words, a credit is subtracted from the taxes you owe, rather than the income you will be taxed on.
Let’s look at Mike’s income again with only tax credits:
If Mike makes $75,000 a year and his salary is taxed at a 22% rate then without any credits or deductions his owed taxes would be $16,500.
Luckily, Mike has $4,000 worth of tax credits. When assessing the taxes Mike owes a 22% tax rate would still be applied to his $75,000 income giving him a tax liability of $16,500. However, before his tax bill is assessed $4,000 is subtracted from the $16,500 giving him an actual tax liability of $12,500.
As you can see, the $4,000 in tax credits saved Mike $4,000.
What is a Refundable Tax Credit?
Tax credits are broken into refundable tax credits and non-refundable tax credits. A refundable tax credit allows you to exceed your tax liability. This means that the IRS will refund you for these types of credits, even if they add up to more than you owe.
In Mike’s case, if he owed $16,500 in taxes, but had $17,000 of refundable tax credits, then the IRS would actually owe him $500.
What is a Nonrefundable Tax Credit?
A nonrefundable tax credit only counts towards the actual taxes that you owe. Meaning that even if you have tax credits that are worth more than the taxes you would’ve owed the IRS you wouldn’t get refunded for that money.
Let’s look at Mike’s taxes again. If he owed $16,500 in taxes and had $17,000 worth of nonrefundable tax credits, then his tax bill would just be $0.
Basically, refundable tax credits are a lot more valuable than nonrefundable tax credits if you have more credits worth more than your tax liability.
Tax Credit vs Tax Deduction
Now that we’ve looked at tax credits and tax deductions, which is better? Usually, a tax credit will end up saving you more money than a tax deduction, because it’s applied directly to the taxes that you owe. However, using a combination of credits and deductions is the best way to save money.
Let’s take a look at Mike’s taxes again with both credits and deductions applied:
As a reminder, Mike makes $75,000 a year with a 22% tax rate leaving him with a $16,500 tax bill if neither credits nor deductions have been taken.
Mike doesn’t have a lot of deductible expenses so he takes the standard deduction of $12,950. Therefore, the 22% tax rate is applied to $62,050 of his income resulting in $13,651 of taxes being owed.
However, Mike also has his $4,000 worth of tax credits. Therefore, the $4,000 is taken off the $13,651 giving him a total of $9,651 in taxes owed. The difference between his original $16,500 owed and his new tax bill is $6,849!
As you can see from Mike’s tax situation, a combination of both tax credits and tax deductions will ultimately save you the most money.
What Type of Tax Credits Can I Take?
The type of tax credits available change on a yearly basis. You should check the IRS website yearly to see which ones you qualify for.
Some of the more common tax credits ones include:
- Lifetime learning credit
- Child tax credit
- Credit for other dependents
- Earned income credit
- Adoption credit
- Low-income housing credit
What Type of Tax Deductions Can I Take?
Tax deductions outnumber tax credits. If you are willing to put the work in, you can usually qualify for more deductions than the standard deduction.
Some commonly claimed deductions include:
- Out-of-pocket charitable contributions
- Moving expenses
- Gambling loss
- IRA and 401(k) deduction
- Student loan interest paid by your or someone else
- State and local taxes
The list appears to be infinite. To see which deductions you may qualify for check the IRS website.
How Do I Get the Most Out of Credit and Deductions?
Figuring out the tax credits and deductions you are eligible to take can be an extremely overwhelming process. Overlooking a deduction or credit may mean that you are paying more to the IRS than you should be.
We can assist you in optimizing your tax return so that you catch every credit and deduction that you qualify for. Reach out today to avoid combing through the IRS guidelines and have us do all the work for you.