There are a variety of methods to decrease your tax burden. Two of the more popular ones are tax credits and tax deductions. While these may seem like the same thing, they are two very different mechanisms. Whether you’re an individual or a couple looking to lower your taxable income, you may ask yourself which is better and what’s the difference in credits vs. deductions.
Tax credits give you a dollar-for-dollar reduction of the tax you owe, while tax deductions lower your taxable income for the year. Both tax deductions and tax credits can save you money. For help with your tax strategy, consider working with a tax professional who can not only answer your questions but help to point you in the right direction for credits and deductions that best suit your needs.
Tax Credits: The Basics
Tax credits reduce the amount of taxes you owe, dollar for dollar. For example, if you qualify for a $1,500 tax credit and owe $3,000 in taxes, the credit will reduce your tax liability by $1,500. Your ability to qualify for a particular tax credit depends on several factors, including income, age, and tax filing status.
While claiming tax credits could provide you with a larger refund, some credits are non-refundable. This means if the credit reduces your tax liability to a negative number, what is left over cannot be used to increase the size of your tax refund. For instance, if you have a $1,500 tax credit but only owe $1,400 in taxes, the extra $100 will not be refunded. These are commonly referred to as nonrefundable tax credits.
A refundable tax credit, on the other hand, can help increase your tax refund. The Earned Income Tax Credit is a refundable tax credit. There are also partially refundable tax credits, such as the American Opportunity Tax Credit. With these tax breaks, part of the credit is refundable, and part is nonrefundable.
Here is a list of some other common tax credits:
- Child and Dependent Care Credit (designed to help offset the cost of childcare or taking care of an elderly parent)
- Adoption Credit (for adoption expenses)
- Child Tax Credit (for parents of dependent children)
- Premium Tax Credit (for people who purchased health insurance through the federal marketplace)
- Saver’s Credit (for people who contributed to a tax-advantaged retirement account)
- Lifetime Learning Credit (for higher education expenses)Do your research or find a complete list of tax deductions and tax credits the Internal Revenue Service (IRS) has available in 2023 on their website.
Tax Deductions: The Basics
As we mentioned above, tax deductions lower your taxable income for the year. There are two ways to claim deductions. One option is to claim the standard deduction. That is the kind of deduction that any taxpayer can claim automatically. How much you can deduct depends on your filing status. The most significant standard deduction is for couples filing a joint tax return.
If you do not wish to take the standard deduction, you may itemize your deductions instead. Itemizing involves listing all expenses you want to write off on your return. Itemizing your deductions generally only makes sense if your total deductible expenses are higher than the standard deduction.
Below are some examples of deductible expenses for the tax year 2022:
- Charitable donations
- Mortgage loan interest
- Medical and dental expenses
- Tuition and fees
- Contributions to a traditional IRA
- Contributions to health savings accounts (HSAs)
- Mileage for business travel
- Unreimbursed business expenses
- Moving expenses to start a new job
- Job search expenses
- Teacher’s educational expenses
- Property and real estate taxes
While some must be itemized, others, such as the student loan interest deduction, are known as above-the-line deductions. You can claim above-the-line deductions as separate deductions even if you are not itemizing your deductions.
Remember that your ability to claim certain deductions may be limited depending on your filing status and household income. Another thing to keep in mind is that you cannot claim credit and a deduction for the same qualified expense. For example, if you paid out-of-pocket to go back to school for a graduate degree, you couldn’t claim both the tuition and fees deduction and the Lifetime Learning Credit.
Tax Credit vs. Tax Deduction: Which One Is Better?
Tax credits are generally better than tax deductions because they directly reduce the amount of tax you owe. The effect of a tax deduction on your tax liability depends on your marginal tax bracket. If you’re in the 10% tax bracket, for example, a $1,000 deduction would only reduce your taxable income by $100 (0.10 x $1,000 = $100).
However, depending on what federal income tax bracket you fall in, you may need a mix of credits and deductions to help ease the impact of your income taxes. If you are eligible for both a tax credit and a deduction for the same expenses, crunching some numbers can help you determine which will offer the most significant break at tax time.
Tax credits and tax deductions both decrease the total that you’ll pay in taxes, but they do so in different ways. A tax credit is a dollar-for-dollar reduction of the money you owe, while a tax deduction will decrease your taxable income, leading to a slightly lower tax bill. Ask your tax professional which works best for you during tax season.
Tips for Lowering Your Tax Bill
- A financial advisor can help you limit your tax liability in various ways. Finding a financial advisor doesn’t have to be complicated. We have 7 Questions You Should Ask a Financial Advisor before you hire one, as well as What Is a Fiduciary Financial Advisor and Why Do You Need One?
- Ask your tax or financial professional about the benefits of a tax credit vs. a deduction.
- If you prefer doing taxes on your own, but want to make the most of itemized deductions and tax credits, consider becoming a member of Planning Made Simple. As a member of this one-of-a-kind community, you’ll have access to resources like articles and videos that can help to answer your questions. Community members can also help to answer questions, or you can choose to work with your assigned Planning Made Simple coach, who can not only answer questions but help to point you in the right direction.