When income tax returns come due in April, you might be scrambling to prepare them on time. You'll want to paint a great picture for the IRS so you can lessen your tax liability. Part of reducing that liability is knowing the difference between a tax credit and a tax deduction.
Tax Credits and Deductions
The main difference between a tax credit and a deduction is the formula used to calculate how they are applied to your overall income.
Video of the Day
A tax credit subtracts dollar for dollar from your taxable income. A tax deduction subtracts a percentage from your income based on your tax bracket.
Tax Credits Lower Amounts Owed
A tax credit lowers the tax you pay on your earned income. It eliminates a specific dollar amount depending on the credit. For instance, with the dependent care credit, if you owe the IRS $700 and have a tax credit of $200, you'll only owe the government $500. It wipes out $200 of the amount of tax owed.
An earned income credit (EIC) is for people who have made less than $56,844 that year. The EIC may give you money back at tax time or lower the federal taxes you owe. An example of an earned income credit is the child tax credit. A credit of up to $3,000 is allowed for a qualifying child between the ages of 6 and 17. There is also a tax credit of up to $3,600 if a qualifying child is less than 6 years old.
Consider also: How to Take the Sting Out of Taxes
Tax Deductions Lower Taxable Income
A tax deduction lowers your taxable income. For example, assume that the income tax bracket for a gross income of $25,000 was 20 percent. If you had a $1,000 tax deduction, 20 percent of a $1,000 is $200. The $200 would be the deduction applied to your gross taxable income. Once all your deductions are applied, you are then left with your adjusted gross income (AGI), which is what will be taxed.
There are two types of deductions: One is the standard deduction and the other is an itemized deduction.
A standard deduction is a flat rate designated by the IRS and is tied to inflation. Certain taxpayers aren't eligible to claim this deduction:
- those married and filing separately if your spouse itemizes their deductions
- a nonresident or dual-status alien
- those filing a return for less than 12 months due to a change in their annual accounting period
- an estate, trust, common trust fund or a partnership
If you take advantage of the standard deduction, you cannot itemize deductions.
Itemized deductions also reduce the income tax liability. Just as it sounds, it's a list of qualified expenses you can subtract from your gross income:
- education expenses
- some healthcare expenses
- home mortgage interest
- health savings account (HSA)
- charitable donations
- student loan interest
- dental expenses
If you wish to itemize your deductions, you should use schedule A when you file. When itemizing deductions, it's a good idea to keep all receipts and records of your deductions in the event of an audit.
A self-employed small business owner working out of their home can deduct the portion of the home used for the business. Car expenses used for business can also be deducted.
Consider also: How to File Taxes from Previous Years
Take Advantage of Deductions and Credits
The first step to taking advantage of tax credits and deductions is to know your tax bracket. Tax calculators like the one from TurboTax are available online. A tax professional can help you take advantage of tax deductions and credits that affect your personal finances.
- TurboTax: What are Tax Credits
- USAgov: Tax Benefits
- IRS: Earned Income Tax Credit
- TurboTax: What are Standard Tax Deductions
- IRS: Tax Topics 551 Standard Deductions
- Ramsey Solutions: What is a Tax Deduction
- TurboTax: What is My Tax Bracket
- H&R Block: What’s the Difference Between a Standard Deduction and an Itemized Deduction
- IRS: IRS Provides Tax Inflation Adjustments for Tax Year 2021
- IRS: Should I Itemize?
- IRS: Definition of Adjusted Gross Income
- IRS: American Opportunity Tax Credit
- TurboTax: Tax Bracket Calculator 2021
- NOLO: When Home Sellers can Reduce Capital Gains Tax Using Expenses from Sale