Most people confuse tax credits and tax deductions, thinking they’re basically the same. They both offset money owed to the IRS. However, one of them is much better than the other.
Why should you care about whether tax credits and deductions are the same? Because they can each save you a ton of money if you know what they are and how to use them.
Tax credits vs. tax deductions might sound like a dull topic for the upcoming tax season, but knowing the difference can literally change how you spend, and what financial decisions you make during the year.
The Basics of Tax Deductions
Let’s start with tax deductions, as this is probably the benefit that most people will recognize.
When taking a tax deduction, you get to deduct money from your income. If you make $60,000 a year and take $10,000 worth of tax deductions, you will only be taxed on the first $50,000 of your income.
However, tax deductions won’t save you as much as people think. You only save the percentage of your tax deduction that corresponds to your tax bracket. If you’re in the 22% tax bracket, a $1,000 deduction will save you $220. Nice but not nearly as much as people typically expect.
There are countless things that people can deduct on their taxes. The most popular among many people is the mortgage interest deduction. In addition to that, state taxes can usually be deducted (with limits), local taxes can be deducted (with limits), charitable donations, and student loan interest all apply.
Tax deductions can be powerful because they accumulate. But their power depends entirely upon your tax bracket. Deductions are worth more to higher-income families than they are to low-income families.
Why Tax Credits Are Even Better Than Tax Deductions
Tax credits are much better because they reduce what a person owes to the IRS dollar for dollar.
A $1,000 tax credit will take $1,000 off of the amount you owe the IRS, not a penny less. It won’t matter what tax bracket you’re in or even if you owe taxes at all.
Certain refundable credits (like the Earned Income Tax Credit) will actually issue you a refund if you qualify for a credit that is higher than what you owe. Nonrefundable credits will just bring your tax bill down to $0 but won’t give you any additional refund beyond that.
Tax credits appear much better than tax deductions in virtually every way that matters. They’re not just equalizers among low- and high-income taxpayers; they’re actually significantly more valuable regardless of the differences between the two.
Tax credits get taxpayers excited when filing as tax professionals because everyone deserves the same benefits regardless of their financial situation.
The Numbers Behind Tax Deductions vs. Tax Credits
Some numbers behind tax deductions vs tax credits will make the difference clear. Let’s say that someone who is in the 22% tax bracket has the choice between a $2,000 tax deduction or a $2,000 credit (hypothetically, of course).
They would save $440 with the tax deduction (which is 22% of the total). But with the tax credit, they would save $2,000! The same exact amount but with vastly different value as an outcome. For someone in the 12% income tax bracket, they would save only $240.
This is an important aspect of the tax credit vs tax deduction decision that cannot be avoided. This is why tax professionals are so skilled at finding credits; they are equalizers among taxpayers of all income levels.
A family earning $50,000 a year receives just as much benefit from a tax credit as an individual who earns $150,000 per year. It makes no sense to avoid making more money just so you can find some tax credits.
When You May Need Professional Help Finding Tax Credits
Many people fail to receive credits just because they don’t know that they exist. The IRS has several credits that taxpayers may qualify for that allow for special treatment.
Some of the credits that taxpayers can receive include the Child Tax Credit that allows parents to take a credit on behalf of their children, the American Opportunity Tax Credit for educational expenses, the Lifetime Learning Credit, Energy Credits for energy-saving home renovations, Saver’s Credits for retirement savings, the Child and Dependent Care Credit, and other credits for unique and often changing requirements.
A tax accountant provides taxpayers with credits that they might miss doing their taxes themselves. It seems to make sense that individuals who have low-income and who file their taxes might have very simple incomes.
Credits You May Qualify For
Some popular tax credits to consider include the following:
- Child Tax Credit: Up to $2,000 per child ($1,400 refundable)
- American Opportunity Tax Credit: Worth up to $2,500 (education)—per student (limited to the first four years)
- Lifetime Learning Credit: Worth up to $2,000 per taxpayer
- Saver’s Credit: Awarded to low- and moderate-income taxpayers worth up1 to $1,000 per year (refundable)
- Energy Credits: Multiple energy credits for solar installations and other renewable sources
- Child and Dependent Care Credit: $3000 per credit per dependent needed so that individuals can work or look for work
Each of these credits has its own unique circumstances regarding who may claim them and when it may be utilized.
Examples You May Need Tax Professionals to Help You Find Tax Credits
The difference between tax credits and deductions will be obvious when you make certain purchases or do certain things during the year.
It makes much more sense from a budgeting perspective to be actively engaged in activities that will earn you tax credits rather than earning deductions.
Filing mortgage interest might save people more from paying it each year, but paying for energy efficient home renovations will pay off in more savings thanks to energy tax credits.
It’s quite possible that even more savings can be realized by using discretionary funds to purchase items throughout the year that will earn credits rather than deductions on taxes.
Credits only sometimes apply for the year it is claimed but can also be claimed for future years on separate returns as deductions.
The Bottom Line on Tax Credits vs. Tax Deductions
Overall, the difference between tax credits and deductions is not huge but every time individuals pay taxes seasonally or annually it will add up.
Both taxes apply when it is time to file taxes yet those who file taxes should never be afraid of filing this year.
The real challenge will always be not losing out on money owed by simply being unaware of what may apply to each individual filing his/her tax return.
Thus far it looks like those who apply for fees may suffer catastrophically from things that they miss.
