Tax credits and deductions are two ways to lower your tax payment, but they operate differently and affect your tax liability in different ways.
1. Tax Credit
A tax credit immediately lowers your tax liability on a dollar-for-dollar basis. It is deducted from your overall tax obligation and is a set sum. Tax credits come in two varieties:
- Refundable Tax Credits: You get a refund if the credit is greater than your tax obligation. The Earned Income Tax Credit (EITC) and the Child Tax Credit (which is partially refundable) are two examples.
- Non-refundable tax credits can lower your tax obligation to zero, but if the credit is more than your tax obligation, you will not be refunded. Lifetime Learning Credits and other education credits are examples.
Advantages of Tax Credits
- Greater Value: A credit lowers taxes due by one dollar for every dollar received.
- Targeted Relief: Several credits are designed to promote particular behaviors, such as education, energy conservation, or starting a family.
2. Tax Deduction
By taking a tax deduction, you can lower your taxable income—that is, the amount of money that is subject to taxes. The tax rate on your final dollar of income, or your marginal tax rate, determines the real tax savings.
Deductions can be:
- Standard Deduction: A set sum of money determined by your filing status (married filing jointly, single, etc.).
- Itemized Deductions: Certain costs that you can deduct in lieu of the standard deduction, such as charitable contributions, state and local taxes, mortgage interest, and medical costs.
Advantages of Tax Deductions
- Flexibility: Enables taxpayers to strategically reduce their taxed income.
- Income-Specific Benefits: Because their marginal tax rate is higher, higher-income taxpayers in higher tax brackets gain more from deductions.
Combined Tax Savings
Credits and deductions can frequently be combined by taxpayers to maximize savings. As an illustration:
- claiming the Child Tax Credit and, if qualified, deducting daycare costs.
- Using credits such as the American Opportunity Credit in conjunction with deductions for debt repayment and educational costs.
Final Thoughts
- Generally speaking, tax credits are worth more because they immediately reduce your tax liability. But they frequently have more stringent qualifying standards.
- Taxpayers with large qualified costs or those in higher tax brackets particularly benefit from tax deductions.
Taxpayers can decrease their overall tax burden and maximize their tax strategy by being aware of both instruments.