Tax Credit Versus Tax Deduction: What is Better for Tax Savings?
When it comes to tax planning many people find themselves confused by the terms “tax credits” and “tax deductions.” Although both have the goal of reducing your tax liability they work in ways. So, in order to effectively lower your tax bill, it’s important to understand the distinction between these two concepts as they have an impact on both your state and federal tax filings.
In this blog post we will explain the differences between tax credits and tax deductions so that you can make the most of them during the tax season and save money as possible.
What are Tax Credits?
A tax credit is an incentive offered by the government to decrease the amount of taxes you owe. This means that for every dollar of credit you qualify for your total tax liability is reduced by that amount. For example, if you are eligible, for a $1,000 tax credit your actual tax bill will be decreased by $1,000 immediately. In many cases, a tax credit can even result in a refund.
Tax credits are usually provided for energy-related home improvements, educational expenses, or for adopting children.
There are generally two types of tax credits:
1. Non-Refundable Tax Credits: These credits aim to reduce your overall tax liability. But if your credit exceeds what you owe in taxes, you won’t get a refund. For example, let’s assume you owe $800 in taxes. If you qualify for a refundable tax credit of $1,000, your tax liability will be reduced to zero but you won’t receive the remaining $200 as a refund.
2. Non-Refundable Tax Credits: These tax credits not only lower your tax liability but can also result in a tax refund. Suppose you owe $800 in taxes and are eligible for a tax credit of $1,000; you would actually receive a $200 refund.
Some Common Tax Credits
Here are some common tax credits available in the US:
· Child Tax Credit – This credit provides assistance to families with children under 17 years old. To claim this credit, include your child(ren) on Form 1040 U.S. Individual Income Tax Return. In case if the credit exceeds your tax liability, you may even receive a portion of it as a refund.
· Earned Income Tax Credit (EITC) – EITC is specifically designed to assist individuals with low-to-moderate incomes. The amount of this credit varies based on factors such as your income, filing status, and the number of children you have. If you are eligible, you may potentially receive refunds through this credit.
· The American Opportunity Tax Credit (AOTC) – This credit aims to provide relief for expenses. It offers coverage for students up to $2,500 during their four years of education. Expenses that qualify may include tuition fees and materials required for courses.
· The Lifetime Learning Credit – It is designed to support learning and covers expenses related to education. It provides a maximum of $2,000 per tax return for tuition and other relevant costs incurred at an institution.
· Child and Dependent Care Credit – If you incur childcare or dependent care expenses while working or searching for employment you may be eligible for the Child and Dependent Care Credit. The amount of the credit depends on your expenses with a limit of $3,000 for one qualifying individual or $6,000 for two or more.
· Savers Credit – The Savers Credit aims at encouraging retirement savings among individuals with low to moderate incomes. The government offers a tax benefit of, up to $1,000 ($2,000 for married couples filing jointly) for individuals who contribute to retirement savings plans like IRAs and 401(k)s.
· The Residential Energy Efficient Property Credit – This credit is designed to incentivize homeowners to make energy upgrades such as panels, solar water heaters, and energy-efficient windows. This credit covers 26% of the expenses associated with these improvements making it a great encouragement for adopting eco practices.
· Adoption Tax Credit – Families who choose to adopt children can take advantage of the Adoption Tax Credit which helps with the costs involved in the adoption process. The amount of this credit varies and may even result in a refund depending on your circumstances.
· Foreign Tax Credit – If you have paid income taxes in another country you can benefit from the Foreign Tax Credit. It helps offset your U.S. Tax liability and prevents taxation on the same income.
What is a Tax Deduction?
It’s an expense that you can deduct from your income, which helps to decrease the portion of your income that’s subject to taxation. Unlike tax credits that directly reduce your income tax deductions work by reducing your income through various types of investments.
The value of a deduction depends on your tax bracket – the more the income, the greater the tax reduction. There are two types of tax deductions:
1. Standard Deductions – This is a fixed dollar amount that reduces your taxable income. Most taxpayers need to decide whether to take the standard deduction or itemize their deductions and the specific amount of the deduction varies based on your filing status.
2. Itemized Deductions – It allows you to list expenses you incurred throughout the tax year such as mortgage interest, medical expenses, state and local taxes paid, and charitable contributions. You have the option to itemize deductions if these expenses add up to more than the standard deduction.
Choosing Between Tax Credits and Deductions
When it comes to choosing between tax credits and deductions, it’s important to consider how they will affect your tax liability. Tax credits usually offer a reduction in taxes owed while deductions involve complex calculations based on factors like your total income and specific expenses.
When it comes to choosing between tax credits and deductions, here are some factors to consider:
1. Eligibility: While tax credits and deductions are extremely lucrative, it is important to ensure you qualify for them. Connect with your tax professional to check your eligibility and plan your taxes efficiently.
2. Refundability: If you qualify, it’s beneficial to choose tax credits as they can potentially result in a refund if the credit exceeds your tax bill.
3. Itemizing Deductions: Check if itemizing your deductions would be more advantageous as compared to taking the deduction. Opt for the option that provides maximum tax savings.
4. Seek Professional Advice: Tax laws can be complex and are subject to changes. It’s advisable to consult with a tax financial advisor who can help you make informed decisions based on your specific financial situation.
The Bottom Line
While both tax credits and deductions are tools for reducing your tax liability, they operate differently. Tax credits directly decrease the amount of taxes you owe whereas deductions lower your income. By using them strategically, you can minimize your tax burden and retain more of your hard-earned money. Remember to stay updated on tax laws and seek guidance from professionals for optimal tax management practices.