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What Is a Tax Credit and How It’s Different From a Tax Deduction

admin by admin
February 23, 2022
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While using tax preparation software or even better, a professional tax preparer can ease the burden of preparing your annual taxes, there’s still some work you’ll have to do on your end.

The silver lining of filing a tax return is the potential promise of a refund. And one of the best ways to land yourself in refund territory is by maximizing tax credits and tax deductions. Both are useful strategies to reduce what you owe (or even better, increase what Uncle Sam owes you), but the two are different.

So what’s the difference between a tax credit and a tax deduction — and which is better?

Definitions: Tax Credits and Tax Deductions

Tax credits have a more direct impact on what you owe, dollar for dollar. It is a direct reduction in your total tax bill. For example, if you owe the government $5,000 and you have a tax credit of $2,000, you instead only owe $3,000.

Tax deductions reduce the total amount of your income that is subject to taxation. Deductions used to be more attractive until the federal government raised the standard deduction in 2017 and also removed many itemized deductions.

According to the Urban-Brookings Tax Policy Center, 90% of Americans take the standard deduction rather than itemized, because their deductions don’t exceed the allowable threshold.

While both strategies can impact how much you owe or are owed, tax credits typically yield larger savings especially since the 2017 tax reform. A knowledgeable tax professional (or a paid tax preparation software) will be able to combine the two strategies to get your tax bill as low as possible or, better yet, increase the value of your refund.

How Tax Credits Work

If you qualify for a tax credit, you can apply it to your overall tax bill, reducing what you owe dollar for dollar. Because these have a larger impact and reduce what the federal government can earn from taxpayers, the rules surrounding these are more stringent, and the credits are much more challenging to come by.

There is a long list of tax credits with a lot of complicated jargon surrounding who is eligible and how to apply. If you think you might qualify for one or two but aren’t sure how to proceed, a professional tax preparer might be worth the investment.

Child Tax Credit

The Child Tax Credit is easily the most common tax credit; watch just about any sitcom to see a parent joke about having kids solely for the tax credit. If you have multiple children, you will receive a tax credit for each of them.

For the 2021 tax season (filing in 2022), parents benefit from the passage of last year’s American Rescue Plan, which increased the Child Tax Credit from $2,000 per child to $3,600 per child under 6 and $3,000 for children 6 to 17. This year, the entire credit is refundable (more on that next).

Note: If you received an advance payment of this credit ($1,800 or $1,500) during the 2021 tax year, you will not be able to apply the full $3,600 or $3,000 tax credit to your return. You’ll want Letter 6419 when filing to determine how much you can claim; the IRS began sending these out in December 2021.

Refundable Tax Credits vs. Nonrefundable Tax Credits

One drawback of tax credits is that not all are refundable. For example, if you owe the government $2,000 and you have a nonrefundable tax credit of $3,000, you will not get a refund check for $1,000. Instead, both you and Uncle Sam will walk away empty-handed.

List of IRS Tax Credits

Child Tax Credits are the most well-known, but you can also get tax credits for things like driving an electric vehicle or paying for college tuition. Find the full details on each of the tax credits below on the IRS website:

  • Child Tax Credit
  • Recovery Rebate Credit
  • Earned Income Tax Credit
  • Child and Dependent Care Credit
  • Adoption Credit
  • Credit for the Elderly or the Disabled
  • Saver’s Credit
  • Foreign Tax Credit
  • Credit for Tax on Undistributed Capital Gain
  • Credit for Prior Year Minimum Tax
  • Residential Energy Credit
  • Plug-in Electric Drive Vehicle Credit
  • Health Coverage Tax Credit
  • American Opportunity Tax Credit
  • Lifetime Learning Credit

How Tax Deductions Work

Tax credits help you out dollar for dollar and are thus the preferred strategy for reducing your tax burden. But you can also reduce what you owe with a deduction.

Tax deductions are likely what you are more familiar with. Whether you take the standard deduction or itemized deduction, this strategy reduces the total amount of your adjusted gross income (AGI) that is subject to income tax.

Taking the Standard Deduction

Taking the standard deduction is certainly easier in terms of sitting at your computer and crunching numbers (or letting TurboTax crunch them for you).

Each year, the IRS establishes one flat rate for each category of filer: single, head of household, married filing separately and married filing jointly. No matter your financial situation, you are free to claim this standard deduction that applies to everyone.

The IRS has released the standard deduction rates for the 2021 tax year (filing in 2022) and the 2022 tax year (filing in 2023).

Not sure of your filing status? The IRS offers a useful tool to figure it out; it takes roughly 5 minutes to complete.

Itemizing Your Deductions

If you think you might get a larger overall deduction if you itemize individual deductions, you can go that route. TurboTax and similar tax preparation software, or an actual accountant, can help you identify what these deductions might be, but you will need paperwork to back things up.

Common deductions to itemize include:

  • Charitable donations
  • Home mortgage interest
  • Disaster losses
  • Medical expenses
  • Prior year state and local income tax
  • Personal property taxes
  • Business expenses as a freelancer
  • Gambling losses
  • Student loan interest

If, after itemizing all your deductions, it amounts to less than the standard deduction, don’t proceed. Take the standard deduction instead.

Tax Credits vs. Tax Deductions: Example Scenarios

Want to see how tax credits and tax deductions work in comparison? Review our example scenarios to see how each reduces what you owe. In each scenario, we are assuming an Adjusted Gross Income (AGI) of $75,000 and thus a 22% tax bracket.*

Tax Credit Scenario

Congratulations. You’ve qualified for a tax credit of $5,000. That takes $5,000 off your total tax bill. At the 22% tax rate on $75,000 AGI, you would owe $16,500, but you can take $5,000 off that total tax burden; you now owe the government $11,500.

($75,000 AGI at 22% tax rate) – $5,000 tax credit = $11,500

Tax Deduction Scenario

Congratulations. You’ve qualified for a tax deduction of $5,000. That reduces your AGI to $70,000. At the 22% tax rate on $70,000, you owe the government $15,400.

($75,000 AGI – $5,000 tax deduction) at 22% tax rate = $15,400

Tax Credit vs. Tax Deduction: Which Is Better?

As you can see, tax credits can save you more on your tax bill. However, you can use both tax credits and tax deductions together strategically to maximize your tax savings.

And remember, nonrefundable tax credits can’t earn you any money; they’ll just reduce what you owe.

Bottom Line

Both tax credits and tax deductions can dramatically reduce what you owe the government and, ultimately, might be your key to getting a refund check come April. If researching potential credits and deductions and determining eligibility sound too complicated, consider a professional tax preparer. They will likely save you far more than the $200 or so it will cost for professional tax preparation.

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