What is the Difference Between Tax Credits and Tax Deductions

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Tax Liability

Your tax liability is the total amount of tax on your income minus any non-refundable credits such as child tax credits and dependent care credits to name two.  Your tax liability can also include additional taxes like self-employment tax, household employment tax, and tax penalties.

Tax credits and tax deductions are arguably the best things we have in our tax system. Both will reduce your tax liability and help you save money on your tax return but in different ways.

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Tax credits directly reduce the total tax due, while tax deductions reduce your overall taxable income.

But let’s take a closer look at the differences between the two:

How Do Tax Deductions Work?

Suppose you earn $100,000 a year and your tax rate is 20 percent. By default, your total tax due would be $20,000. Let’s suppose you run a business and you declare $10,000 as a business expense. Now your taxable income is $90,000 and you only pay $18,000 instead of $20,000.

No deductions$10,000 deduction
Annual Gross Income (AGI)$100,000$100,000
Taxable Income$100,000$90,000
Tax Rate20%20%
Total Tax Due$20,000$18,000

Keep in mind that tax codes can vary on both the federal and state levels.

Standard Deductions

The standard deduction takes into account other applicable deductions. So if you can only account for $600 in itemized deductions, obviously, you would take the standard deduction instead of trying to itemize. That’s why the standard deduction works best for those who have a simple return. A benefit of the standard deduction is you don’t have to worry so much about tracking your expenses. This is great for young adults or for those who have less complicated financial activity.

The benefit of taking the standard deduction is you don’t have to worry so much about tracking your expenses. This is great for young adults or for those who have less complicated financial activity.

Itemized Deductions

However, let’s suppose you have more going on financially. You have a mortgage, a business, you’re donating to charity, etc. then you may consult with an accountant to see how much you’d save if you itemized your deductions.

What are some examples of itemized deductions?

  • Interest on a mortgage
  • Donations to charity
  • Business expense
  • Medical and dental expenses
  • Student loan interest

The amount you can save on each can change every year. It’s best to consult with your local accountant to see how much you can declare on each item.

How Do Tax Credits Work?

Simply put, an income tax credit will directly reduce your tax bill. There are a wide variety of income tax credits at both the state and federal levels that you can potentially use when filing tax returns. Unlike tax deductions, which reduce the amount of taxable income, credits directly reduce a tax bill. Of course, each of these has many stipulations, and the average person usually will be eligible for only a few of them each year, if any.

When it comes to choosing tax credit or tax deduction you can only choose one.

Again, let’s suppose you earn $100,000 a year. However this time you can’t take a tax deduction. But let’s suppose you’re granted with a $10,000 tax credit. This means, with a 20% tax rate, you would owe $20,000 BEFORE the tax credit, and once the credit has been applied you will owe only $10,000. This is significantly less than $18,000 with the $10,000 deductions.

No Tax Credit$10,000 Tax Credit
Annual Gross Income (AGI)$100,000$100,000
Taxable Income$100,000$100,000
Tax Rate20%20%
Tax Due$20,000($20,000-$10,000) $10,000

What are nonrefundable tax credits?

If you receive a refundable tax credit, you can get a refund even if you don’t owe any tax liability.  This is the opposite of a non-refundable tax credit which can also result in a refund to the taxpayer, but not below the amount of tax liability they owe. 

During the 2019 tax year an example of a nonrefundable tax credit was mortgage interest credit.

What are partially refundable tax credits?

There are some tax credits that are partially refundable. For instance, during the tax year of 2018, the Child Tax Credit was partially refundable (up to around $1,400 per qualified child). So you may be able to get a partial refund if you reduced your tax liability to nothing. This can change year to year and from one tax credit to another.

What are refundable tax credits?

Most people get excited when they receive refundable tax credits. This is because if they owe nothing on their tax bill, and they have a leftover from their tax credit, the taxpayer is entitled to the remainder of the money. For instance, during the tax year of 2019, one of the more popular refundable credits was the Premium Tax Credit.

What Are Some Examples of Tax Credits?

Say, for example, that due to effective tax planning, you do not owe any taxes. Your tax bill for the year is zero. If this is the case and if you have earned refundable tax credit, you are entitled to a refund of the amount of the credit! Here are some examples of tax credits to offset your tax bill.

The Child Care Credit is one of the most common expenses for couples filing jointly. Payments to child care providers can be used to offset your tax bill. The maximum expense you can claim for one dependent is $3,000 and $6,000 for two or more qualifying dependents. There are some stipulations. For example, your child must be 12 years old or younger.  Also, the total expense incurred will be reduced if you receive child care benefits from your employer (if this applies).

The government has offered some attractive credits for electric and hybrid vehicles. The Electric Vehicle tax credit is up to $7,500. In most cases, this represents the maximum credit permitted for using an electric vehicle and can be used to offset your total tax bill. Understand that if your electric car is leased, the credit does not go to you. Also, Electric Vehicle tax credit was limited to a certain amount of production by each of the major automotive manufacturers.  Once they made and sold that many EV’s, the tax credit for that model phases out.

The Earned Income Tax Credit (EITC) is a benefit for those working fewer hours or for those who are self-employed. The benefit amount is calculated based on income and/or number of dependents.

Improvements to your home could earn a Home Energy Credit in which you can claim up to 30 percent of the total cost of alternative energy equipment installed at your residence.

Contact Marcus, Fairall, Bristol + Co., PLLC for Any Tax Questions

If you’re looking to ask a CPA (Certified Public Accountant) about any tax-related questions whether it be tax filing, tax planning, or if you have any tax issues, give our firm a call. We’ve been providing El Paso, TX with tax services for over 30 years!

Marcus, Fairall, Bristol + Co., PLLC
CPA Firm in El Paso, TX
230 Thunderbird Dr Ste G, El Paso, TX 79912
Phone: (915) 775-1040
Email: info@dmarcusmarcfair.com
Visit: https://marcfair.com