It's no secret that the tax code and therefore tax season can leave many Americans awash in anxiety with questions abounding. Thankfully, when it comes to preparing your taxes, the idea of tax credits and tax deductions can be music to every taxpayer’s ears. Both are used to lower the amount of taxes someone owes to good old Uncle Sam. While they’re both worth getting excited over, it’s important to understand the fundamental difference between these two terms.
What Are Tax Credits?
It is not uncommon to hear the phrase "Tax credits are better than tax deductions" and that may be true, but what are Tax Credits? Simply put, tax credits are reductions on the amount of actual tax owed. These credits will not lower your taxable income nor will they change your tax bracket. Rather, they are reductions that come after the fact. - after your tax professional has determined what is owed to the government (based on your taxable income & tax bracket). There are a few common types of tax credits that can be given based on your income level, if you have been blessed with children, you’re a college student and more. These common credits include:
Child Tax Credit
Child and Dependent Care Credit
Lifetime Learning Credit
Earned Income Tax Credit
Residential Energy Tax Credit
Tax credits are typically either refundable or non-refundable. Depending on which type of credit it is, this will affect how much you’ll receive back on your tax refund.
Refundable Tax Credits
Refundable tax credits are tax credits that allow you to be refunded the remaining, unused portion of a credit. For example, say you owe $900 in taxes, but your eligible child tax credit is worth $2,000. Not only will this cover the $900 you owe in taxes, but you will also be refunded the remaining $1,100. It’s important to note that in recent years, certain tax credits (including the child tax credit) have been reformed to include caps on the amount of refundable credit given through the Tax Cuts and Job Acts passed in 2018.1
Non-Refundable Tax Credits
Alternatively, non-refundable tax credits will only cover the amount in taxes you owe, up to the credit’s limit. If there is more in the credit amount than what you owe, you do not receive the excess amount in the form of a tax refund. For example, if you owe $900 in taxes and your tax credit is worth up to $2,000, the $900 will be covered but you will not receive the additional $1,100.
What Are Tax Deductions?
Tax deductions are used to reduce the amount of income that Uncle Sam considers eligible to be taxed. By way of deductions, you the American tax payer, have the ability to reduce your taxable income, which in turn may allow you to lower your tax bracket or at a minimum, lower the amount of money taxed at your highest tax rate. There are typically two types of tax deductions: itemized deductions and above-the-line deductions.
You can use itemized deductions to help lower your taxable income. Common types of itemized deductions include:
While people are welcome to add each deduction up separately on their taxes (i.e. itemize them), nearly 90% of tax payers will opt for the standard deduction2 set by the IRS because, in most cases, an itemized amount won’t exceed the IRS’s standard deduction rates. For the 2019 income tax year, these were the standard deduction amounts:
Single or married but filing separately: $12,200
Married and filing jointly or qualifying widow(er): $24,400
Head of household: $18,3503
Above-the-line deductions are used to reduce your adjusted gross income (AGI). These deductions can be very significant when all are added together, thus allowing you to qualify for certain itemized deductions and tax credits. Your adjusted gross income is determined by subtracting above-the-line deductions from your gross income. This lower AGI can then allow you to claim important tax credits or deductions that may be dependent on income level. Common above-the-line deductions include:
Student loan interest
Deductible IRA contributions
Moving expenses of armed forces members
Tax credits and tax deductions can both be very useful tools to benefit taxpayers, especially when they work in tandem. Familiarizing yourself with the difference between these two tax terms gives you a great place to start understanding the deductions and/or credits you may be eligible for this year come tax time.
|About the Author|
James M. Comblo , CFF
is a Partner and the Chief Compliance Officer at FSC Wealth Advisors. His greatest passion in the financial services industry is helping clients accomplish their dreams both with investments and their personal lives. To learn more about him click here.
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