What’s the difference between a tax credit and a tax deduction?
How to take advantage of these important ways to reduce your tax bill
Nobody wants to pay any more in taxes than they have to. When it comes to reducing your tax burden, you have two key tools: tax deductions and tax credits. Understanding how they work and how to find them can help ensure you don’t miss out on any potential savings. Let’s explore the difference between a tax credit and tax deduction.
Tax deductions reduce the amount of your income the government uses to calculate the amount of tax you owe. Since the tax you owe is a percentage of your income, the amount of savings you’ll get from a deduction varies depending on how much you make overall.
All taxpayers qualify for some tax deductions. Many people simply take the standard deduction, which for the 2020 tax year reduces taxable income for those married filing jointly by $24,800 ($12,400 for single taxpayers). Households with a lot of deductible expenses may be able to get a larger reduction in their taxable income by itemizing their deductions instead. For instance, you can typically deduct the interest you’ve paid on home mortgages and student loans as well as most charitable contributions. You can also deduct up to $10,000 in taxes paid to state or local jurisdictions.
Whether you take the standard deduction or not, you may be able to deduct other expenses and offset some of your taxable income. For example, if you run a business out of your home, you may be able to take advantage of deductions for your home office and other business expenses.
You may also deduct contributions to traditional IRAs as long as you meet certain criteria. Tax deductions are different than tax credits because they reduce your taxable income.
Tax credits get subtracted directly from the amount of tax you owe. In some cases, if you have enough of the right type of tax credits, you can reduce your tax burden to zero — or the government may even wind up owing you a refund.
There are two types of tax credits:
- Non-refundable. You can use non-refundable tax credits to offset the amount of tax you owe. However, you cannot take any more non-refundable credits once you have zeroed out your tax bill.
- Refundable. When you qualify for a refundable tax credit, you receive the full amount of that credit — even if that means you receive some (or all) of the credit as a refund.
Some credits include both refundable and non-refundable elements. For example, the Child Tax Credit allows you to deduct $2,000 per under-17 child, and $1,400 of the credit is refundable. So even if you did not owe any tax at all, you could receive $1,400 of this credit as a refund, assuming you qualified for it. And if you owed anywhere between $1,400 and $2,000 in taxes, taking this credit would reduce your bill to zero.
Because tax credits can have an even bigger effect on your overall tax bill than deductions, it’s critical to make sure you take them if you’re qualified to do so. Remember there is a difference between a tax credit and a tax deduction. Fortunately, the IRS provides a comprehensive list of tax credits and deductions that you can consult to make sure you don’t miss out. While there are differences between tax credits and tax deductions, both may help you save on the taxes you owe.
This material is for informational purposes only and is not intended to provide tax recommendations or advice.
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