Tax Credits vs. Tax Deductions - What’s the Difference?

There are two major categories of tax breaks: tax credits and tax deductions. While they sound similar, they are very different. Both tax breaks reduce your tax bill in different ways. Below are the basics of tax credits and deductions including examples of common credits and deductions.

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‍Tax Credits

Tax credits reduce your tax liability; they give you a dollar-for-dollar reduction of the tax you owe. For example, a tax credit of $500 will lower your tax bill by $500. There are many different tax credits, and which credits you qualify for depend, among other things, on your age, income, and tax filing status.

Depending on the type of credit, tax credits can be refundable, partially refundable, or nonrefundable.

- Refundable credits: If the refundable credit is more than the tax bill, the difference will be included in your tax refund.

- Partially refundable credits: If your tax bill is less than the partially refundable credit, you only get a portion of the difference in your tax refund.

- Nonrefundable credits: These credits can lower your tax bill but are not included in your tax refund.

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Common tax credits include:

- Adoption Credit (for adoption expenses)

- Child Tax Credit (generally, credit for taxpayers with children under the age of 17)

- Earned Income Tax Credit (helps low-to-moderate income workers)

- Child and Dependent Care Credit (helps you pay for the cost of childcare or care for dependents)

- American Opportunity Credit (credit for qualified education expenses for an eligible student for the first four years of higher education)

- Premium Tax Credit (available to people who purchase health insurance through the federal marketplace)

- Saver’s Credit (for people who contribute to tax-advantaged retirement accounts)

- Lifetime Learning Credit (helps pay for higher education expenses, not restricted to undergraduate expenses)

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Tax Deductions

Tax deductions are different from tax credits because they reduce your taxable income, based on your tax bracket. For example, if you are in the 10% tax bracket, a $5,000 deduction will reduce your taxable income by $500. Some tax deductions (known as below-the-line deductions) can be claimed if you choose to itemize deductions instead of claiming the standard deduction. Other tax deductions are above-the-line deductions, meaning you can claim them even if you are not itemizing your deductions.

Common tax deductions include:

- Contributions to a traditional IRA (above the line)

- Contributions to Health Savings Accounts (above the line)

- Capital Losses (above the line)

- Medical Expenses that exceed 7.5% of your adjusted gross income (below the line)

- State and Local Taxes (below the line)

- Mortgage Loan Interest (below the line)

- Charitable Contributions (below the line)

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Conclusion

Tax credits and tax deductions are both beneficial ways to decrease your tax burden; taxpayers can potentially claim both types on their tax returns. This article is not an exhaustive list of deductions and credits; many more are available for qualifying taxpayers. Depending on which credits and deductions you take can save you lots of money on your taxes. Speak with a tax professional to find out which credits and deductions you qualify for today.

Contact Provident Legal Counsel to discuss your federal tax situation with a dual-credentialed attorney and CPA. Schedule a Consultation or call (214) 432-6100.