Scoring as many tax breaks as possible can make the filing process a little easier to bear, especially if you end up getting a big refund or owing less money to Uncle Sam. Claiming tax credits and deductions can go a long way toward shrinking your income tax bill. But they work in very different ways. Here’s a quick breakdown of the difference between tax credits and deductions.
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 you owe $3,000 in taxes, the credit would reduce your tax liability by $1,500. Your ability to qualify for a particular tax credit depends on several factors, including your income, age and tax filing status.
While claiming tax credits could leave you with a bigger refund, some credits are non-refundable. This means that if the credit reduces your tax liability to a negative number, what’s left over cannot be used to increase the size of your tax refund. For instance, if you have a $1,500 tax credit but you only owe $1,400 in taxes, the extra $100 won’t be included in your refund check.
A refundable tax credit, on the other hand, can help boost your tax refund. The Earned Income Tax Credit is a refundable tax credit. There are also partially refundable tax credits, like the American Opportunity Tax Credit. With these kinds of tax breaks, part of the credit is refundable and part of it is nonrefundable.
Here’s 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)
What Are Tax Deductions?
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’s the kind of deduction that any taxpayer can claim automatically. How much you can deduct depends on your filing status. The largest standard deduction is set aside for married couples filing a joint tax return.
If you don’t want to take the standard deduction, you can itemize your deductions instead. Itemizing involves listing out individual expenses that you want to write off on your return. Itemizing your deductions generally makes the most sense if your total deductible expenses are higher than the standard deduction.
Here are some examples of deductible expenses for tax year 2017. While some of them must be itemized, others (like the student loan interest deduction) are above-the-line deductions. You can claim above-the-line deductions as separate deductions even if you’re not itemizing your deductions.
- 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
Keep in mind that your ability to claim certain deductions may be limited depending on your filing status and household income. Another thing to remember is that you can’t claim a credit and a deduction for the same qualified expense. If you paid out-of-pocket to go back to school for a graduate degree, for example, you couldn’t claim the tuition and fees deduction and the Lifetime Learning Credit.
Tax Credit vs. Tax Deduction: Which One Is Better?
Tax credits are generally considered to be 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).
Still, if you’re eligible for both a tax credit and a deduction for the same expenses, crunching some numbers can help you determine which one will offer the biggest break at tax time.
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