Tax Credit vs. Tax Deduction
Tax season is once again upon us, and many of us have likely wanted to avoid the hassle of filing them. However, that would be considered tax evasion, and we are definitely not advocates of skipping out on taxes. Nevertheless, you may be enthused to hear that tax avoidance may be possible to reduce the amount you owe.
Tax avoidance is legal and allows you to lower your taxes through tax credits and deductions. Although the terms seem interchangeable, there are differences between tax credits vs. tax deductions. Fortunately, we have outlined how they work and can be applied to decrease your yearly tax bill.
What Is a Tax Credit?
Tax credits can lower the amount of taxes you owe dollar for dollar. For example, if you owe $3,000 in taxes and qualify for a $1,000 tax credit, you will end up owing $2,000. However, there are two kinds of tax credits: refundable and nonrefundable .
If your nonrefundable tax credit exceeds the amount you owe, you will not receive a refund check for the outstanding tax credit that was not applied. For example, if you owe $300 and qualify for a $500 nonrefundable tax credit, you will not receive a check for the extra $200.
Conversely, you may receive a refund check for refundable tax credits that exceed the amount you owe. Some common tax credits include:
- American Opportunity Tax Credit
This tax credit helps students or taxpayers with dependent students claim expenses associated with the first four years of higher education. Up to $2,500 can be claimed, and the tax credit is partially refundable. However, only 40% or up to $1,000 can be refunded.
- Child Tax Credit
This is a fully refundable tax credit for eligible families with children. To qualify, families must earn a minimum of $2,500.
- Saver’s Credit
This is a nonrefundable tax credit for employer-sponsored and individual retirement accounts. The tax credit only applies to certain contributions to the account. Typically, the tax credit can be 10% to 15% based on qualification, contributions, and income.
What Is a Tax Deduction?
Tax deductions lower how much of your income is taxed. Tax deductions are subtracted from your income before your taxes are calculated. Additionally, the amount of your tax deduction is determined based on your income tax bracket.
Let’s say your annual income is $45,000. This means your income tax rate is 22%. Additionally, you qualify for a $5,000 deduction. To determine your savings, you must multiply the deduction amount by the income tax rate ($5,000 x 22%). As a result, the deduction would save you $1,100. Typically, individuals paying higher income tax may benefit more from tax deductions.
Like tax credits, there are two types of tax deductions: standard and itemized . The standard tax deduction depends on your filing status and is a one-size-fits-all model. Standard tax deductions lower how much of your income is taxable. Taxpayers don’t need to provide extra documentation to qualify for the standard tax deduction. For 2022, the standard tax deduction amount varies as follows:
|
Filing Status |
Standard Tax Deduction Amount |
|
Single |
$12,950 |
|
Married, filing jointly |
$25,900 |
|
Married, filing separately |
$12,950 |
|
Head of household |
$19,400 |
Conversely, itemizing allows taxpayers to list individual expenses that they can write off. Typically, the itemizing method is used when the itemized amount exceeds the standard tax deduction amount. Some itemized deductions include:
- Charitable contributions
- Medical and dental expenses
The deduction amount depends on income and only covers certain qualified medical and dental expenses. Nevertheless, taxpayers may deduct these expenses for themselves, dependents, or spouses.
- Mortgage interest
- Business expenses
If you work from home and have a dedicated office space, you may deduct a portion of your rent or property tax. The deduction amount will be based on your eligibility and the square footage of the office space.
- Property and real estate taxes
- Teacher’s expenses
Eligible teachers may deduct up to $250 in qualified teaching-related expenses, such as books, development courses, or supplies.
Keep in mind that you cannot combine standard and itemized tax deductions. Taxpayers must choose one. As a result, it is important to calculate your deduction amount through both methods to see how you can maximize your savings.
Difference Between Tax Credit and Tax Deduction
When deciding between a tax credit vs. tax deduction, you will need to consider your income and tax rate. If your income and tax rate are high, you will likely benefit more from a tax deduction. However, tax credits often offer more savings because they are not connected to your income tax rate. Instead, you receive dollar-for-dollar savings.
For example, let’s compare the savings of a $1,000 tax credit vs. a $1,000 tax deduction. Your savings with a tax credit will be straightforward: $1,000 off your tax bill.
Determining the savings of a $1,000 deduction takes more calculations. First, you will need to determine your income tax rate. Let’s say you are in the 22% bracket. You’ll multiply your deduction amount with your tax rate to determine your savings ($1,000 x 22%). As a result, you’ll save $220.
In this instance, it is clear which option is better: tax credits.
Final Thoughts
As with anything tax and IRS-related, it is best to consult a tax expert . Although we aim to provide you with comprehensive and up-to-date information, we are not licensed tax professionals. Hopefully, with this newfound information, yearly taxes won’t be too dreadful. Whether you opt for tax credits or deductions, you may save more than you anticipated this year.
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