Tax Credit vs. Deduction: How Are They Different?

The tax system can be confusing. A common source of confusion is the difference between a tax credit and tax deduction. Both can save you money, but they work differently. In this article, we’ll explain the difference between a tax credit vs deduction to help you approach your tax returns strategically and save the most on your taxes.

We know that your taxes can feel overwhelming, so we are here to help. Our team of experts is skilled in resolving tax issues, whether they involve tax credits, deductions, or owed tax debts. Use our free tax consultation to evaluate your tax situation and determine the best action to resolve any tax issues you may have.

What Is a Tax Credit vs Deduction?

Tax credits and deductions are two different tools to reduce your tax liability. A tax deduction is a purchase made with the intent of producing additional income which is later subtracted from your income to reduce taxable income and tax liability. A tax credit is a tax incentive that reduces your income tax liability dollar for dollar.

Put more simply, tax deductions lower your taxable income, while tax credits directly lower your tax liability. Both tax credits and deductions have strict qualifications and rules that must be met to claim them.

Tax Credits Directly Lower Your Tax Bill

Imagine if you could just slice off a chunk of your tax bill and watch it shrink. That’s what tax credits do. You can subtract their amounts of money straight from your taxes owed. Think of it like a gift card that you use when you’re ready to pay the taxman.

For instance, if you owe $2,000 in taxes and get a $500 tax credit, you now only pay $1,500. These credits come in various forms, like credits for education expenses, adopting children, or retrofitting your home with energy-efficient systems. Each credit has its rules and qualifications, but the result is the same: your tax bill goes down.

The great thing about tax credits is their simplicity. They have a value that does not change regardless of your income level or tax bracket. Since they work by reducing your tax bill dollar for dollar, they often provide more savings than deductions. Some credits are even refundable, meaning if you reduce your tax liability to zero, the IRS will send you the remainder of the credit as a refund.

Deductions Reduce Your Taxable Income

While credits deal with your tax bill directly, deductions are more indirect. They lower the amount of your income that’s subject to taxes. Consider them as discounts on your taxable income.

For instance, if you earn $50,000 and have a $1,000 deduction, you are then taxed as if you made $49,000. Deductions range from mortgage and student loan interest to charitable donations and medical expenses. The key with deductions is they depend on your tax bracket – a deduction will save you a portion of each dollar deducted based on your rate.

To illustrate, if you’re in the 22% tax bracket, a $1,000 deduction saves you $220 (22% of $1,000). Unlike credits, deductions can require more effort to understand their full benefit. They might not feel as satisfying as the direct hit of a credit, but they add up. Over time, they work to lighten your tax load by lowering the base amount your tax is calculated on.

The Case for Tax Credits

The Value of a Tax Credit Is Constant

The beauty of tax credits is their unchanging value. Whether a college student or a retiree, a dollar in tax credit means a dollar less than what you must pay. Their consistency offers reassurance amidst the ever-changing tax rules and regulations.

Consider that in times of financial struggle, every penny counts. A tax credit could mean the difference between owing money and receiving a refund. Tax credits are often more beneficial than deductions for those with tax debts.

Refundable credits, in particular, are powerful tools. They can eliminate any tax owed and put money back in your pocket, which is especially powerful if you’re working with a professional to manage your tax liability. While deductions can save you money by reducing the income you’re taxed on, the tax credits often tip the scales in your favor.

Tax Credits Can Be Refundable or Non-refundable

A pivotal distinction in the credit realm is refundable and non-refundable credits. Here’s the difference: refundable credits can lower your tax bill below zero, while non-refundable ones cannot.

Take refundable credits. Let’s assume you owe $800 in taxes but are eligible for a $1,000 refundable credit. This would wipe out your tax bill, and you’d receive the leftover $200 as a refund. Refundable credits can help you reduce and entirely eradicate your tax burden.

Non-refundable credits, while still valuable, do not offer the possibility of a refund. Let’s use the previous example. If the $1,000 credit were non-refundable, it would wipe out your $800 tax liability, but the remaining $200 would not be paid to you. The government would keep it. Non-refundable credits can still take a significant bite out of your tax bill, yet they won’t bring you that additional refund check.

Deduction Savings Depend on Your Tax Bracket

The relief that deductions bring depends on your tax bracket. The higher your tax rate, the more money you save with every deduction. This fact makes deductions especially beneficial for those in higher tax brackets. A deduction reduces the income you’re taxed on, so naturally, the higher your tax rate, the more value each deduction has.

Let’s assume you’re in the 24% tax bracket. A $200 deduction from your taxable income saves you $48 ($200 times 24%). If you were in the 10% tax bracket, that $200 deduction would save you only $20. Therefore, deductions are more beneficial if you earn more, as they reduce a larger proportion of the tax you’d otherwise owe.

Take Control of Your Taxes with TaxRise

Don’t let tax issues weigh you down. Let TaxRise’s expert team resolve them so you can focus on what matters most. Contact us today and start reclaiming control over your tax situation.