I often hear people mix up tax credits and tax deductions so I thought it could be helpful to break down what each of them are and how they work so you can know what the differences are. I will say, both are great for reducing your total tax liability and something you want to be aware of.
Tax Deductions
Tax deductions reduce how much of your income is subject to taxes. So they reduce your tax bill by the percentage of whatever your highest federal income bracket is for you. If you are in the 24% tax bracket, a $5,000 tax deduction would reduce your tax bill by ($5,000 x . 24% = $1,200).
An Example:
| Ex: A $15,00 tax deduction | |
| Your AGI | $200,0000 |
| Minus your tax deduction | $15,000 |
| Taxable Income Left | $185,000 |
| Multiple By Your Tax Rate (simplify to 1 number for example purposes) | 32% |
| Total Tax Paid | $59,200 |
| How much the tax deduction saved on taxes | $5,800 |
As you can see, having a $15,000 tax deduction in this example helped them save $5,800 on taxes. Not bad right? I hope you can now understand that a tax deduction just reduces what your income is and then you multiply your tax rate by your lower income after the deduction.
Here are some examples of different tax deductions you have at your disposal:
- Property Taxes
- Mortgage Interest
- State Taxes Paid
- Real Estate Expenses
- Charitable Contributions
- Medical Expenses
- Pre-Tax Retirement Contributions (401(k), traditional IRA, etc.)
- HSA Contributions
With tax deductions, some people choose to just take the standard deduction, a one size fits all reduction. It is $12,950 for singles in 2022 and $25,900 for married filing jointly. The standard deduction is just choosing to take that total amount for your deductions instead of itemizing them one by one.
This is a little bit more into the weeds, but you can take the standard deduction and also still deduct some things that are ‘above-the-line-deduction’. Above-the-line deductions are expenses that are deducted to calculate an individual’s adjusted gross income (AGI). These differ from itemized deductions, which are the dollar amounts deducted from the determined AGI. Some examples are:
- Retirement Plan Contributions:
- HSA, MSA Contributions
- Health Insurance premiums
- Self-Employed Business Expenses, SE Tax
- Alimony:
- Educator Expenses:
- Early Withdrawal Penalties:
- Student Loan Interest:
- Tuition and Fees
Tax Credits
Tax Credits give you a dollar for dollar reduction of your tax liability. They are even better than tax deductions because they directly reduce the amount of tax you owe. So if you have a $1,000 tax credit, it actually reduces your tax bill by $1,000 unlike tax deductions which lower it by ($1,000 x your tax rate).
Let’s look at an example here as well of how tax credits work:
| Ex: A $15,00 tax credit | |
| Your AGI | $200,0000 |
| Minus your tax deduction | $0 since it’s a tax credit |
| Taxable Income Left | $200,000 |
| Multiple By Your Tax Rate (simplify to 1 number for example purposes) | 32% |
| Total Tax Paid | $64,000 |
| Less: Tax Credit | $15,000 |
| How much the tax deduction saved on taxes | $49,000 |
As you can see, with tax credits you subtract the total credit from the amount of tax you owe which reduces your tax bill dollar for dollar by the amount of the credit. Tax credits are very impactful!
Here are a few things you need to know about tax credits though:
- Some tax credits are nonrefundable: This means that if you don’t owe much in taxes in the first place, you won’t end up being able to fully use the tax credit. Let’s say you owe $2,000 in tax and have a $5,000 tax refund. If it is nonrefundable, then it will lower your tax bill to $0, but you won’t get that extra $3,000 back. So you are unable to fully use it.
- Some tax credits are refundable: Some tax credits are refundable though, meaning you can get money back from them, they won’t just lower your tax bill to $0. So in the example above, you owe $2,000 in tax and have a $5,000 tax credit, so if it is refundable, you would get $3,000 back on your taxes.
- Some tax credits that work like this are the earned income tax credit and the child tax credit.
Here are a few of the tax credits to be aware of:
- Child Tax Credit
- Credit for other dependents
- Child and Dependent Care Credit
- Earned Income Tax Credit (EITC)
- The Retirement Contribution Savings Credit (Saver’s Credit)
- American Opportunity Tax Credit (AOTC)
- Lifetime Learning Credit (LLC)
I hope this helps you better understand the differences between tax credits and tax deductions for the future! Try and take advantage of all of them you have at your disposal.
