What Is the Difference Between a Tax Credit and a Tax Deduction?
Tax credits and tax deductions. You know they are good things, but what are they? They are both opportunities to lower the amount of taxes you owe to the government. But what’s the difference and how do they work?
What Are Tax Credits?
Simply put, tax credits are reductions on the amount of actual tax owed. Tax credits in no way affect your tax bracket or taxable income. Instead, think of these as reductions that come after the fact - i.e. after you’ve determined how much you owe to the government. There are a few common types of tax credits that can be given based on your income level, whether or not you have children, if you’re a college student and more. These common credits include:
- Child Tax Credit
- Child and Dependent Care Credit
- Lifetime Learning Credit
- Adoption Credit
- Earned Income Tax Credit
- Residential Energy Tax Credit
Tax credits are typically either refundable or non-refundable. Depending on which type of credit it is, this will affect how much you’ll receive back on your tax refund.
Refundable Tax Credits
Refundable tax credits are tax credits that allow you to be refunded the remaining, unused portion of a credit. For example, say you owe $900 in taxes, but your eligible child tax credit is worth $2,000. Not only will this cover the $900 you owe in taxes, but you will also be refunded the remaining $1,100.
Non-Refundable Tax Credits
Alternatively, non-refundable tax credits will only cover the taxes you owe, up to the credit’s limit. If there is more in the credit amount than what you owe, you do not receive the excess amount in the form of a tax refund. For example, if you owe $900 in taxes and your tax credit is worth up to $2,000, the $900 will be covered but you will not receive the additional $1,100.
What Are Tax Deductions?
Tax deductions are used to reduce the amount of income that’s eligible to be taxed. By reducing this amount, your income may fall into a lower tax bracket, meaning you’re subject to pay a lower tax rate. There are typically two types of tax deductions: itemized deductions and above-the-line deductions.
You can use itemized deductions to help lower your taxable income. Common types of itemized deductions include:
- Charitable donations
- Medical expenses
- Property taxes
- Mortgage interest
While people are welcome to add each deduction up separately on their taxes (i.e. itemize them), most will opt for the standard deduction set by the IRS. For the 2022 income tax year, these are the standard deduction amounts:
- Single or married but filing separately: $12,950
- Married and filing jointly or qualifying widow(er): $25,900
- Head of household: $19,4001
It is common to use a standard deduction because, in most cases, an itemized amount won’t exceed the IRS’s standard deduction rates.
Above-the-line deductions are used to reduce your adjusted gross income (AGI), which can qualify you for certain itemized deductions and tax credits. Your adjusted gross income is determined by subtracting above-the-line deductions from your gross income. This lower AGI can then allow you to claim important tax credits or deductions that may be dependent on income level. Common above-the-line deductions include:
- Student loan interest
- Educator expenses
- Health Savings Account contributions
- Deductible IRA contributions
- Deductible portion or self-employment tax
- Contributions to self-employed retirement plans
- Health insurance premiums for self-employed people
Tax credits and tax deductions can both be a great benefit and understanding them will help you to better understand your tax return and your tax situation, and therefore steward your resources better. If you want to take it a step further and understand your whole financial situation, consider working with us to create a comprehensive financial plan. Schedule a free call today to learn more about it.
About Guide Financial Planning
Guide Financial Planning is led by founder Ben Wacek, who is a Christian fee-only Certified Financial Planner™ and Certified Kingdom Advisor®. He has a passion to help people of all income levels make wise financial decisions and steward their resources from an eternal perspective using Biblical principles. Based in Minneapolis, MN, he works with clients both locally and virtually throughout the country and abroad. You can follow the links to learn more about Guide Financial Planning and our team and the services we offer.