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Tax credits and tax deductions are two common ways people lower their income tax bills. Although similar in intention, these two tax-reduction methods have fundamental differences and are not interchangeable. Knowing the difference can have a big impact on your bottom line.
Basically, tax credits lower your tax amount, dollar for dollar; whereas tax deductions reduce your taxable income. The ultimate value of a deduction depends on your tax bracket: So, if you’re in the 25 percent tax bracket, $1,000 in deductions might lower your tax bill by $250 (25 percent); but a $1,000 credit can lower your tax bill by the full $1,000, no matter what your tax bracket.
Read on for more differences:
Tax Credits. There are two basic types of tax credits: refundable and non-refundable.
With refundable tax credits, if you owe less in income tax than your eligible tax credit(s), not only do you pay no tax, you actually get a refund for the difference. So for example, if you owe $750 in income tax but have $1,000 in refundable credits, you will receive a $250 refund.
Common refundable credits include: Earned Income Credit for low-income workers; Additional Child Tax Credit for certain people who get less than the full amount of the regular Child Tax Credit; and a credit for those with more than one employer who had too much Social Security tax withheld.
Most tax credits are non-refundable, which means they can’t reduce taxes owed to less than zero (i.e., they can’t generate a refund when the credit amount is greater than taxes owed). Common non-refundable credits include those for: standard child credit; child and dependent care; elderly or disabled people; American Opportunity (an enhanced version of Hope Scholarships – up to 40 percent refundable for most people); lifetime learning; adoption; residential energy efficiency; and retirement savings contributions for low-income families.
Tax Deductions. For many people, it’s more advantageous to take the standard deduction, which is subtracted from gross income to determine taxable income. Others, with large medical, state and local tax, charitable donation and other expenses are better off itemizing deductions.
Common tax deductions include those for: medical and dental expenses exceeding 7.5 percent of adjusted gross income; deductible taxes paid elsewhere (state, local and foreign income tax, property tax, sales tax, etc.); home mortgage points; charitable contributions; casualty and theft losses; and certain education and work-related expenses.
Some miscellaneous deductions, like unreimbursed employee expenses, professional dues, job search expenses and tax preparation fees, must exceed a combined 2 percent of adjusted gross income to be claimed; others, like gambling losses up to the amount of winnings, are not subject to that limit.
You cannot claim a credit and a deduction for the same expense. For example, you may be able to claim work-related tuition as a miscellaneous business expense deduction or as a lifetime learning credit, but not as both.
Eligibility and rules for tax credits and deductions can be extremely complicated and may change from year to year, so refer to the IRS website @link href=’http://www.irs.gov’target=”_blank”>www.irs.gov/link for details. Or, for online links to background information on the credits and deductions mentioned above, read “Tax Credits and Deductions” at Practical Money Skills for Life, Visa Inc’s free personal financial management program @link href=’http://www.practicalmoneyskills.com/deductions’target=”_blank”>www.practicalmoneyskills.com/link