When it comes to preparing your taxes, the idea of tax credits and tax deductions can be music to any taxpayer’s ears. That’s because both are used to lower the amount of taxes someone owes to the government. While they’re both worth getting excited over, it’s important to understand the fundamental difference between these two terms.
What Are Tax Credits?
In other words, tax credits are reductions on the amount of actual tax owed. Tax credits in no way affect your tax bracket or taxable income. Instead, think of these as reductions that come after the fact - i.e. after you’ve figured out how much you owe the IRS. Some of the common types of tax credits that can be given based on your income level, whether or not you have children, if you’re a college student and more. Common tax credits may include:
- Child Tax Credit
- Child and Dependent Care Credit
- Lifetime Learning Credit
- Adoption Credit
- Earned Income Tax Credit
- Residential Energy Tax Credit
Depending on which type of credit (refundable or non-refundable), this will affect how much you’ll receive back on your tax refund.
Refundable Tax Credits
Refundable tax credits are tax credits that allow you a refund on the remaining, unused portion of a credit. For instance, if you owe $900 in taxes, but your eligible child tax credit is worth $2,000. Not only will this cover the $900 you owe in taxes, but you may also be refunded the remaining $1,100.
Non-Refundable Tax Credits
On the other hand, non-refundable tax credits will only cover the taxes you owe, up to the credit’s limit. If there is more in the credit amount than what you owe, you do not receive the excess amount in the form of a tax refund. Such as, if you owe $900 in taxes and your tax credit is worth up to $2,000, the $900 will be covered but you will not receive the additional $1,100.
What Are Tax Deductions?
Tax deductions reduce the amount of income that’s eligible to be taxed. By reducing this amount, your income may fall into a lesser tax bracket, which means you’re subject to pay a lesser tax percentage. There are typically two types of tax deductions: itemized deductions and above-the-line deductions.
You can use itemized deductions to help lower your taxable income. Common types of itemized deductions include:
- Charitable donations
- Medical expenses
- Property taxes
- Mortgage interest
While people can add each deduction up separately on their taxes (i.e. itemize them), most people go for the standard deduction set by the IRS. For t2022 , the standard deduction amounts are:
- Single or married but filing separately: $12,950
- Married and filing jointly or qualifying widow: $25,900
- Head of household: $19,4001
It is common to use a standard deduction because, in most cases, an itemized amount won’t exceed the IRS’s standard deduction rates.
Above-the-line deductions are used to reduce your adjusted gross income (AGI), which can qualify you for certain itemized deductions and tax credits. Your adjusted gross income is determined by subtracting above-the-line deductions from your gross income. This lower AGI can then allow you to claim important tax credits or deductions that may be dependent on income level. Above-the-line deductions include:
- Alimony paid
- Educator expenses
- Student loan interest
- Deductible IRA contributions
- Moving expenses of armed forces members
Tax credits and tax deductions can benefit taxpayers, especially when they work in tandem. Familiarizing yourself with these tax terms may help you understand what deductions and credits you and/or your spouse may be eligible for in the upcoming tax year.
Cappuccino Financial is a boutique financial services firm with a focus on helping individuals, families and business owners navigate financial decisions to anticipate their needs and plan for the future.
This content is developed from sources believed to be providing accurate information, and provided by Twenty Over Ten. It may not be used for the purpose of avoiding any federal tax penalties. Please consult legal or tax professionals for specific information regarding your individual situation. The opinions expressed and material provided are for general information, and should not be considered a solicitation for the purchase or sale of any security.