Tax Credit and Tax Deduction – Know the Difference
Understanding the difference between tax credits and tax deductions, both credits and deductions help in reducing your tax liabilities, but in different ways.
- Tax credits provide a dollar-for-dollar reduction of your income tax liability. For example, if you have a tax credit of 10,000, then you would save 10,000 on your taxes.
- Tax deductions reduce how much of your income is subject to taxes. For example, if you are in the 20% tax bracket, a $10,000 deduction saves you $2,000 in tax (0.20 x $10,000 = $2,000).
Tax credits help to reduce your tax liability dollar-for-dollar, but they cannot lower your income tax liability to less than zero. Also, they expire in the year they are used. Breaking it down further, refundable and non-refundable tax credits.
Non-refundable can only reduce the amount of tax owed, the remainder will not be issued as a refund. For example, if your tax bill is $600 dollars and you have a $1,000 non-refundable credit you do not get a $400 dollar refund. The 400 dollar tax credit left over expires that year and cannot be used again.
However, there are also refundable credits, and these can be issued as a refund. Therefore, if the value of the credit goes beyond your tax liability with a refundable tax credit, then it will result in a refund. Using the same example as above, with a $600 tax bill and a $1000.00 refundable credit you will get a $400 refund.
A couple of refundable tax credits are earned income tax credit and child tax credit.
Tax deductions reduce your taxable income. There are two types of tax deductions: standard deduction & itemized deductions. A taxpayer must use one or the other, but not both. It is generally recommended that you itemize deductions if their total is greater than the standard deduction.
The standard deduction is a dollar amount that reduces your tax liability. You can claim the standard deduction on whichever form you file. The amount varies depending on your filing status and is subtracted by your adjusted gross income.
Itemized deductions are typically used when the amount of qualified deductible expenses are more than the standard deductions. If itemized deductions are more than the standard deduction then your taxable income decrease more. Itemizing allows you to take advantage of deductions such as home mortgage interest, real estate taxes, medical expenses and charitable donations to name a few! If you decide to itemize make sure you have supporting documents and records. The catch for itemized deductions is some are based on a minimum amount, which means you can only deduct amounts that exceed the minimum. There is also an income limitation for taxpayers who itemize deductions if your AGI (adjusted gross income) exceeds a certain level.
The main difference here is tax deductions are subtracted from your gross income, while tax credits are subtracted directly from the amount you owe. Tax credit and tax deduction are both great ways to lower your tax liability. As a taxpayer, take full advantage of both to help you pay less income tax. Want to learn more? Call us today! 256.489.1478 or schedule an appointment now.
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