Nobody wants to pay more taxes than necessary, and if you qualify for a tax deduction or credit, you might succeed in lowering your tax burden tremendously. But while some people do use the terms interchangeably, you should know that tax credits and tax deductions aren't the same thing. While a tax deduction lowers the amount of your earnings that's subject to income tax, a tax credit is a dollar-for-dollar reduction of your tax bill. It pays to learn more about deductible expenses and tax credits so you can shield more of your hard-earned money from the folks at the IRS.
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Tax deductions
A tax deduction allows you to exempt a portion of your income from taxes, but the amount of money that saves you will ultimately depend on your effective tax rate. If you earn $60,000 a year and are eligible for $10,000 in tax deductions, it means you'll only be responsible for paying taxes on $50,000 of income. And if your effective tax rate is 25%, that deduction will amount to $2,500 in savings.
Some common tax deductions include:
- Homeowner deductions for mortgage interest, property taxes, and PMI premiums
- Charitable contributions
- Mileage and home office deductions for the self-employed
- Job-related moving expense deductions
- Job search deductions
- Medical expense deductions
- Net losses on investments
Keep in mind that some deductions have eligibility requirements you'll need to meet. For example, in order to claim a medical expense deduction, your out-of-pocket costs will need to have exceeded 10% of your adjusted gross income for the year.
Tax credits
A tax credit is a dollar-for-dollar reduction of your tax liability. Unlike a deduction, where the amount saved ultimately depends on your effective tax rate, tax credits always result in the same type of savings.
Let's say you owe $3,000 on your taxes but are eligible for a $2,000 tax credit. That credit will automatically reduce your tax liability to $1,000, regardless of your tax rate. Though tax credits and tax deductions ultimately serve a similar purpose -- to lower the amount you pay in taxes -- credits achieve this goal more directly.
Tax credits are typically classified as either refundable or nonrefundable. Many of the credits available to taxpayers today are nonrefundable -- meaning they can't reduce your tax liability to below zero. As an example, if you owe $1,000 in taxes and apply a nonrefundable $1,500 tax credit, you'll wipe out your tax liability, but you won't get a check for the $500 difference. With a refundable credit, you'll cancel your tax liability and get the difference refunded to you.
Some common tax credits include:
- The Earned Income Tax Credit, a refundable credit designed to help low-income families.
- The American Opportunity Tax Credit, a partially refundable credit for families paying higher education costs.
- The Lifetime Learning Credit, a nonrefundable credit for families paying higher education costs.
- The Child Tax Credit, a nonrefundable credit for families with eligible dependents.
- The Child and Dependent Care Credit, a nonrefundable credit for parents who pay for childcare in order to work.
Most tax credits have requirements you'll need to meet in order to claim them. For example, because the Earned Income Tax Credit is designed to help low earners, your income will need to fall below a certain threshold in order to take advantage. Similarly, higher earners often aren't eligible for the Child Tax Credit because it begins to phase out at certain income levels.
As you prepare to file your upcoming return, it pays to read up on tax credits and deductions to see which ones you're eligible for. The more you're able to lower your tax bill, the more of your money you'll get to keep.
