As you probably already know, both tax credits and tax deductions help reduce your overall tax liability. You should search for credits and deductions when filing your annual tax return to save you money. While you should take advantage of all the tax breaks you're eligible for, please don't overlook the fact that tax credits and tax deductions are not the same thing.
Don't credits and deductions both mean the same thing?
In a way, they do, but overall, no. They both help reduce your tax bill, but in very different ways. A tax credit directly reduces the amount of tax you owe by giving you a dollar-for-dollar reduction of your tax liability. For instance, a tax credit of $1,500 lowers your tax bill by the corresponding $1,500 amount. A tax deduction differs by reducing how much of your income is subject to taxes. Deductions lower your taxable income by the percentage of your highest federal income tax bracket, also called the marginal tax. Check out our latest blog covering the marginal tax brackets, found here, The More You Make, The More They Take. If you fall into the 22% tax bracket, a $1,500 deduction saves you $330.
Below is a scenario that illustrates the difference between how tax deductions and tax credits work. Clearly both benefits lower your tax bill, but how they are applied differs. It is worth learning about both types of benefits so you can watch for ways to lower your tax bill.
$10,000 Tax Deduction | $10,000 Tax Credit | |
Your AGI | $100,000 | $100,000 |
Tax Deduction | ($10,000) |
|
Taxable Income | $90,000 | $100,000 |
Tax Rate | 25% | 25% |
Calculated Tax | $22,500 | $25,000 |
Tax Credit | ($10,000) | |
Your Tax Bill | $22,500 | $15,000 |
What are some common tax credits?
Some tax credits you can take advantage of are as follows:
Child Tax Credit - A tax credit for families with children below the age of 17. The child tax credit for 2023 could get you up to $2,000 per child, with $1,600 of the credit being potentially refundable.
Earned Income Tax Credit - A tax crdit for low-to moderate-income working taxpayers. The maximum credit for 2023 is $6,728 for those filing jointly with three or more qualifying children.
American Opportunity Tax Credit - A tax credit for qualified education expenses paid for an eligible student for the first four years of higher education. The maximum credit is $2,500 per eligible student.
Lifetime Learning Credit - A tax credit for qualified tuition and related expenses paid for eligible students enrolled in an eligible educational institution. The maximum credit is $2,000 per tax return.
Child and Dependent Care Credit - A tax credit for expenses paid for the care of a qualifying individual to enable the taxpayer to work or look for work. The maximum credit is $3,000 for one qualifying individual or $6,000 for two or more qualifying individuals.
The majority of tax credits are non-refundable, meaning they will be subtracted from your tax balance, but they cannot reduce your income tax liability to less than zero. Tax credits are less common than tax deductions for taxpayers. Tax credits are available for things such as adopting a child, buying a first home, childcare expenses, home office expenses, and caring for an elderly parent. There are additional tax credits available for business owners.
What are some common tax deductions?
There are two main types of tax deductions; the standard deductions and itemized deductions. You may use one or the other, but not both. If your total deductions are greater than the standard deduction amount, then you should itemize.
The standard deduction for 2023 tax year rose to $27,700 up $1,800 from the prior year for married couples filing jointly. For single taxpayers and married individuals filing separately, the standard deduction rose to $13,850, up $900 from the prior year. Head of household tax filing status now has a standard deduction of $20,800, up $1,400 from the amount for tax year 2022. This information can be found on the IRS website at IRS provides tax inflation adjustments for tax year 2023 | Internal Revenue Service. You can claim the standard deduction on Form 1040, Forms & Instructions | Internal Revenue Service (irs.gov).
Itemizing your deduction allows you to take advantage of deductions such as home mortgage interest, medical expenses or charitable donations. If your itemized deductions exceeds the value of the standard deduction, you'll want to itemzie so you pay less tax. You can claim itemized deductions on Form 1040, Schedule A, About Schedule A (Form 1040), Itemized Deductions | Internal Revenue Service (irs.gov).
It is important to determine your eligibility for tax deductions and tax credits before you file. Deductions can reduce the amount of your income before you calculate the tax you owe and credits can reduce the amout of tax you owe or increase your tax refund. For a list of tax credits and tax deductions available for individuals, please visit the IRS website at Credits & Deductions for Individuals | Internal Revenue Service.
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