It’s the time of year when you begin to prepare your tax return by looking through your tax forms and finding the best tax software. After entering the relevant information from your Form W-2 or 1099s you get to the best part: sorting through tax credits and tax deductions that help lower the amount of taxes you owe. However, you may not know much about tax credit vs tax deduction and how it affects your taxes.
Both are important for reducing your tax bill, but they work in different ways. Take a look at our tax credit vs tax deduction guide to know how they differ and what they accomplish.
What Is a Tax Credit?
When you’re wondering about tax credit vs tax deduction information, remember that a tax credit can be claimed on a tax return as a way to reduce your tax liability directly. Simply put, a tax credit reduces the amount of taxes you owe dollar-for-dollar.
For example, if your total tax liability is $10,000 and you receive the child tax credit for $2,000, your total tax bill will be reduced to $8,000 total. Tax credits are much simpler to understand than tax deductions because you add together the credits you claim and deduct them directly from what you owe in taxes. Tax deductions are treated differently.
Benefits of Tax Credits
- Tax Credits Provide More Tax Savings. Because tax credits provide a dollar-for-dollar reduction in your total tax bill, the amount of money you pay to Uncle Sam is less than you would have to pay without it.
- Tax Credits Can Also Be Refundable. Refundable implies you are able to receive any excess tax credit not used to offset your tax liability via a tax refund. These are the best tax credits to receive because they put money back in your pocket, even if you don’t owe any taxes. Imagine owing $1,500 in taxes but receiving a $2,000 refundable tax credit. This means your tax liability would vanish and you would receive a $500 refund. If the tax credit were nonrefundable, you would not receive the unused portion back via a tax refund.
Common Types of Tax Credits
There are a wide variety of tax credits. Two of the common credits that had big changes were the Child Tax Credit and Earned Income Tax Credit.
- Earned Income Tax Credit. The earned income tax credit is a powerful tool to incentivize low-to-middle wage individuals and families to work, parents in particular. Depending on the filing status, income level and number of dependent children, working individuals and families may receive anywhere from $1 to $6,431 as a refundable tax credit. As more dependent children are claimed, the credit increases. However, you do not need children to qualify for the earned income tax credit. If you have no qualifying children, the maximum credit you can receive is $519 in 2018.
- Child Tax Credit. After tax reform in 2018, the child tax credit has had more of an impact. It now reduces your taxes by up to $2,000 per child under the age of 17. Many more families qualify for the credit becomes income limits have increased substantially to $200,000 for individual filers (compared to $75,000 in 2017) and $400,000 for married, filing jointly (compared to $110,000 in 2017). The child tax credit is a refundable tax credit for up to $1,400 per child. You must claim the child tax credit on your return to receive it. Also, every child you claim must have a Social Security number.
Refundable vs. Nonrefundable
Any tax credit you can get is good because they all reduce your tax liability dollar-for-dollar. However, not all tax credits were created equally. Some have more value than others due to their refundable nature.
Aside from possibly putting money in your pocket from any excess refundable credit remaining after reducing your tax liability to $0, refundable tax credits can also offset taxes which can’t be reduced normally. Specifically, they can offset additional Medicare tax, self-employment tax or the surtax on early distributions of retirement savings.
While nonrefundable tax credits also lower tax liability dollar-for-dollar, the unused balance does not come to you via a tax refund. In other words, if you have a $400 tax bill and a $1,000 nonrefundable tax credit, you only reduce your tax bill to $0. The extra $600 is lost and does not come to you via a tax refund.
Given how refundable tax credits provide more value, these are the credits you want to identify if you qualify to claim them. You could pass up money going directly into your pocket if you aren’t careful checking for refundable tax credits.
How to Claim Tax Credits
Whether you use tax return software to prepare your return or do them without assistance, you may check your eligibility for multiple tax credits. To claim ones you qualify for, simply include the necessary documentation supporting your claim and mark them on your tax forms.
Specifically for nonrefundable tax credits, they are entered on Schedule 3 of Form 1040 with the total showing on line 12 of the 1040. Refundable tax credits are entered on Schedule 5 on the Form 1040 of your tax return. The total from this schedule is then transferred to line 17 of the 1040 and is treated the same as taxes you’ve already paid via withholding or estimated quarterly tax payments.
Claiming tax credits is easy when using most tax software because you simply select the qualifying credits and the program does the calculation and schedule populating for you.
If doing your tax return by hand, aside from putting the credits on the right schedules, be careful to do the arithmetic correctly because the IRS scrutinizes returns that claim tax credits more closely, especially if those returns lead to a tax refund.
What Is a Tax Deduction?
The next thing to understand about tax credit vs tax deduction is how tax deductions work. In their simplest form, tax deductions reduce the total amount of taxable income (adjusted gross income) subject to taxation on your tax return. Claiming tax deductions reduces your overall tax liability. Simply, tax deductions reduce the amount of income for which you owe taxes.
Claiming tax deductions lowers your overall tax liability, however, not as effectively as tax credits. As stated above, tax credits reduce the direct dollar amount of your tax bill. Tax deductions can be powerful in lowering your tax liability.
Benefits of Tax Deductions
Tax deductions have some great benefits that you should keep in mind when you’re learning about tax credit vs tax deduction. Here are a few.
- You Pay a Smaller Amount of Taxes With a Lower Taxable Income. Claiming a tax deduction lowers your total taxable income, thereby decreasing the amount of income subject to the highest tax bracket. For example, if you earn $100,000 as a single taxpayer and claim the standard deduction, your total taxable income decreases by $12,000 to $88,000. In this example, the income above $82,501 is taxed in the 24% bracket, resulting in tax of ~$4,200 ([$100,000 – $82,501] * 24%) just for the income earned between $82,501 and $100,000. However, the standard deduction lowers the taxable income subject to this tax bracket by $12,000 and results in tax paid from this bracket of ~$1,320 ([$100,000 – $12,000 – $82,501] * 24%). In this case, the $12,000 standard deduction saves you ~$2,880 on your tax bill.
- You Pay a Lower Effective Tax Rate on Your Taxable Income. If you review how much taxable income you have absent tax deductions, you will see you have an effective tax rate lower than your highest marginal tax rate. To illustrate, imagine you have a taxable income after taking the single taxpayer standard deduction $40,000. Your first level of income ($1 – $9,525) is taxed at 10% or $952.50. Your second tier of income ($38,700 – $9,526) is taxed at 12% or $3,500.88. The final tier ($40,000 – $38,701) is taxed at 22% or $285.78. Combined, you pay $4,739.16. If you divide $4,739.16 by $52,000 ($40,000 + $12,000 standard deduction), your effective tax rate is 9.11%. This is far lower than the 22% tax bracket or even the lowest 10% tax bracket.
As you can see, as you utilize tax deductions to lower your income from the top marginal tax bracket, your effective tax rate will fall even more. This thereby lowers your effective tax rate on your taxable income.
Common Types of Tax Deductions
There are a lot of tax reductions. Two of the most common deductions that had major changes were the standard deduction and the mortgage interest deduction.
- Standard Deduction. After tax reform in 2018, the standard deduction reigns supreme in terms of tax deductions. The law sought to simplify individual tax returns by having a higher hurdle for taxpayers to cross in order to qualify for itemizing their deductions. Previous to tax reform, however, the standard deduction was still the most commonly-claimed tax deduction given few people had sufficient deductions to itemize to begin with. Tax reform made it even harder to itemize. Now, the standard deduction has essentially doubled for most filing statuses and also compensates for the loss of personal exemptions. Many taxpayers will find this simplifies their annual tax planning and tax preparation because there is even less chance they will qualify to itemize. However, just because you are unable to itemize deductions at the federal level, you may still have deductions worth tracking for your state income tax return (if applicable). Therefore, you should still make an effort to track these expenses because they could result in a lower tax bill at the state level.
- Mortgage Interest Deduction. Another popular tax deduction many people have claimed in the past is the mortgage interest deduction. Previous to tax reform, homeowners were allowed to deduct the interest paid on mortgages associated with the first $1,000,000 of their principal and $100,000 of home equity lines of credit (HELOCs) as long as the funds were used toward qualified home expenses. Now, the amount has dropped to $750,000 for new mortgages originated after December 15, 2017. Existing mortgages are grandfathered in under tax reform and can still be claimed as deductions against your taxable income. When using results from a loan calculator, factor in the loss of tax deductibility of those costs above $750,000. High cost-of-living areas or wealthy taxpayers are the individuals most subject to this tax rule change.
How to Claim Tax Deductions
Much like tax credits, when you prepare your tax return using either tax software, by hand or through the use of a tax professional, you will need to include the tax deductions for which you qualify. Doing so will reduce your taxable income and result in lower overall tax liability.
Tax Credits vs Tax Deductions: Which Is Better?
Unquestionably, in the battle of tax credit vs tax deduction, tax credits provide a better chance at paying less in taxes. They directly offset your tax liability whereas tax deductions reduce your taxable income, allowing you to pay less on your marginal tax bracket.
Depending on how much income you make, this could be substantial savings. However, tax credits provide you more reward. Because of this, tax credits are better than tax deductions in tax credit vs tax deduction situations.
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