Tax Credits vs. Tax Deductions for Individuals

When it comes to tax season, you may hear about tax credits and deductions and wonder – what’s the difference? Both can lower your tax bill, but they work differently. Knowing what they are and how they impact your tax situation can benefit you and your business.

What is a tax deduction?

A tax deduction lowers your taxable income. For example, say you make $50,000 this year and have a tax deduction of $5,000. That means you only have to pay income taxes on $45,000 of your earnings. 

Deductions directly lower the amount of income you get taxed on but cannot increase your refund.   

What is a tax credit? 

A tax credit directly reduces how much tax you owe. Think of it like a direct discount on your tax bill. Let’s say you make $50,000 and owe $5,000 in taxes. If you have a $1,000 tax credit, now you only have to pay $4,000. 

It brings down your tax bill, not your taxable income. Some tax credits can be refundable, meaning you can receive a check for the remaining amount even if you don’t owe any taxes. 

Take a look at these examples…

Client 1 has a taxable income of $45,000 this year. She owes $4,900 in federal taxes. She makes a $1,000 401(k) contribution and is eligible for a $2,000 child tax credit. Here’s how it works:

  • Her 401(k) contribution is a deduction, lowering taxable income to $44,000.
  • The $2,000 child credit directly reduces taxes owed from $4,900 to $2,900.

Client 2 has taxable income of $35,000 and owes $2,800 in taxes. He paid $4,000 in mortgage interest and donated $500 to charity.

  • His $4,000 mortgage interest is a deduction, lowering taxable income to $31,000.
  • The $500 charity gift is also a deduction making taxable income $30,500.

The overall tax burden for each client was impacted based on the deductions and credits applied.

Common Tax Credits

Earned Income Tax Credit (EITC) – This credit benefits low to moderate income individuals and families, especially those with children. For example, a married couple making $25,000 with 2 kids could qualify for an EITC over $5,000!

Education Credits – Paying college tuition for yourself or dependents can make you eligible for credits like the American Opportunity Credit (up to $2,500) and the Lifetime Learning Credit (up to $2,000). 

Child and Dependent Care Credit – If you pay expenses like daycare or babysitting so that you can work and earn income, you may qualify for this credit worth 20-35% of those costs. For most folks the expenses are capped at $3,000 for one child or $6,000 for two or more children.

Popular Federal Income Tax Deductions 

In addition to mortgage interest and charitable donations, some other sizable deductions can also help shrink your taxable income. These include:  

  • State and Local Taxes – You can deduct state/local income taxes and property taxes up to $10,000 total. This includes your state income tax bill from last year’s filing. 
  • Medical and Dental Expenses – Your out-of-pocket healthcare expenses above 7.5% of your adjusted gross income are deductible. This can include copays, prescriptions, dental work not covered by insurance, and mileage for appointments.
  • Work Expenses – Teachers, military reservists, performing artists and other select jobs may deduct work expenses like uniforms, supplies, training costs, travel between job sites, union dues, and more.

While both tax deductions and tax credits save you money on taxes, a deduction brings down how much of your money can be taxed, and a credit brings down the amount of tax owed. Generally, tax credits are considered more valuable than deductions because of the dollar-for-dollar reduction. 

Maximizing both to keep more of your hard-earned money is a result of tax planning.  Regular meetings with a proactive tax advisor to discuss changes or anticipated changes to your personal and/or business situation can help you plan decisions that have tax consequences and minimize your tax burden.

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