Tax credits and tax deductions are the two ways that you can reduce the amount you owe in taxes, and even increase the amount you receive in your tax refund. But if you must choose between the two, which one will give you the greatest dollar-for-dollar benefit? How do tax credits and tax deductions work, and what are the differences between the two? Here is all you need to know about these two types of tax benefits.
What Is a Tax Credit?
A tax credit offers you a direct reduction of your tax liability. So, if you calculate your taxes and find that you owe the IRS $1,800, but you qualify for a $1,000 tax credit, your tax bill will be reduced to $800, allowing you to keep every bit of that $1,000 credit in your bank account.
There are two general kinds of tax credits—refundable tax credits, and nonrefundable tax credits. A nonrefundable tax credit can reduce your tax liability to $0; however, you will not receive a refund for any excess tax credits. So, let’s assume you owe $1,800 in taxes, but qualify for $2,000 in nonrefundable tax credits. Your tax liability is now $0, but you won’t receive a refund.
On the other hand, if you qualify for a $2,000 refundable tax credit, you would reduce your tax bill to $0 and then receive the excess as a $200 tax refund from the IRS. Obviously, refundable tax credits can offer you some excellent benefits if you qualify for them.
Common Tax Credits
Tax credits are typically offered when you experience any sort of life-altering circumstance. This might include:
- Having a child (including adoption)
- Paying for college or trade school
- Caring for an elderly parent
- And more
When you meet with one of our Provo CPAs, they’ll ask you a series of questions about your current life circumstances to help you determine which tax credits you should qualify for on your 2018 tax return.
One of the most common tax credits available is the earned income tax credit (EITC). This credit is designed to help reduce the tax liability of lower-income families, so you must fall below a certain adjusted gross income level to qualify. However, those who do qualify for this credit could potentially receive several thousand dollars in refundable tax credits.
What Is a Tax Deduction?
While a tax credit offers you a reduction in your tax liability (and a potential refund), a tax deduction simply reduces your total taxable income in the eyes of the IRS. As an example, let’s say your taxable income is $35,000, but you learn you qualify for a $1,000 tax deduction. This means you will only be taxed on $34,000 of your income, instead of the full $35,000.
What does this mean for your bank account? Well, the exact amount of money it saves you will be based on your tax bracket, so you can calculate the benefit by multiplying the total tax deduction by your tax rate. As an example, let’s say you’re taxed at 32% and you qualify for a $1,000 tax deduction. This means the deduction essentially puts $320 back in your pocket (1,000 x 0.32).
Common Tax Deductions
When you file your taxes, you get to choose between a standard deduction amount or itemizing your deductions. The standard deduction amounts for 2018 are as follows:
- Individuals, or married couples filing separately – $12,000
- Heads of household – $18,00
- Married couples filing jointly – $24,000
These amounts may be slightly higher for the elderly or the disabled. The majority of people choose to take the standard deduction amount, but if you have a large amount of deductions, and their value exceeds the amount offered by the standard deduction, you may choose to itemize your deductions. Common tax deductions that you can include in your itemized deductions include:
- Medical expenses (if exceeding 7.5% of your adjusted gross income)
- Charitable contributions
- Mortgage interest
- State income tax
- Property tax
- And more
Our tax experts will review your itemized deductions and help you to determine whether you should take the standard or itemized deduction amount on your 2018 tax return.
So Which Is Better?
So, when comparing a $1,000 tax credit with a $1,000 tax deduction, it is usually more beneficial to take the tax credit. This will put more money back in your pocket that a deduction of the same amount.
If you want to learn more about tax credits and deduction, or you have questions about which ones you might qualify for, reach out to one of our Provo CPAs to make an appointment today.