As our federal tax code gets more and more complex, it can be challenging to navigate through all of the ways you can save money by lowering your income taxes. Two of the more common methods people use to reduce their income taxes are tax credits and tax deductions. Although similar in intention, these two tax-reduction techniques have fundamental differences and are not interchangeable. Knowing the difference can have a big impact on your bottom line.
Basically, tax credits lower your tax amount, dollar for dollar, whereas tax deductions reduce your taxable income. The ultimate value of a tax deduction depends on your tax bracket. Simply put, if you're in the 25 percent tax bracket, $1,000 in deductions might lower your tax bill by $250 (25 percent X $1,000); but a $1,000 credit can lower your tax bill by the full $1,000, no matter which tax bracket you are in.
Read on for more differences between tax credits and tax deductions:
Tax Credits. There are two basic types of tax credits: refundable and non-refundable.
With refundable tax credits, if you owe less in income tax than your eligible tax credit(s), not only do you pay no tax, but you actually get a refund for the difference. So for example, if you owe $750 in income tax but have $1,000 in refundable credits, you will receive a $250 refund.
Common refundable credits include:
- Earned Income Tax Credit for low-income workers -- amounts vary based on family size and income (Click HERE to see if you are eligible)
- Additional Child Tax Credit for certain people who get less than the full amount of the regular child tax credit (See IRS Publication 972 for details)
- Excess Social Security Withheld Tax Credit -- for people who had more than one employer during the year and too much Social Security tax withheld. (Click HERE for details.)
Most tax credits are non-refundable, which means they can't reduce taxes owed to less than zero (i.e., they can't generate a refund when the credit amount is greater than taxes owed). Common non-refundable credits include:
. There are many different types of income tax deductions. For many people, it's more advantageous to take the standard deduction
, which is subtracted from gross income to determine taxable income. Others, with large medical, state and local tax, charitable donation and/or other expenses are better off itemizing deductions
Among the more common tax deductions are those for:
- Medical and dental expenses that exceed 7.5 percent of your adjusted gross income
- Deductible taxes you paid elsewhere (for example, state, local and foreign income tax, property tax, sales tax, etc.)
- Home mortgage points
- Charitable contributions
- Casualty and theft losses
- Certain education and work-related expenses. Some miscellaneous deductions, like unreimbursed employee expenses, professional dues, job search expenses and tax preparation fees, must exceed a combined 2 percent of your adjusted gross income to be claimed; others, like gambling losses up to the amount of winnings or casualty/theft losses from income-producing property, are not subject to that limit.
- Click HERE for a more complete list of deductions.
It's important to note that you cannot claim a credit and a deduction for the same expense. For example, you may be able to claim work-related tuition as a miscellaneous business expense deduction or as a Lifetime Learning Credit, but not as both.
Your eligibility for tax credits and deductions may change from year to year due to tax law modifications and changes in your income or family situation. For example, some tax credits phase out for people whose adjusted gross income (AGI) exceeds certain levels. With the American Opportunity Credit, for example, single filers whose AGI exceeds $80,000, will see their available credit amount gradually deecrease until at $90,000, the credit is no longer available (the range is $160,000 to $180,000 for couples filing jointly). It pays to check the IRS website
for such details before filing your tax return.
This article is intended to provide general information and should not be considered tax or financial advice. It's always a good idea to consult a tax or financial advisor for specific information on how tax laws apply to you and about your individual financial situation.
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