January 24, 2023

tax credits vs tax deductions

Tax season is officially here. As you prepare to file your tax return, it might be helpful to research ways to decrease your tax liability. A popular way to do this is to claim tax credits and tax deductions. Credits and deductions often seem like the same thing, but they are different. Here’s a comparison of the two. 

What is a tax credit? 

A tax credit is a dollar-for-dollar reduction of your income. They are created by the federal and state governments to encourage certain behaviors that benefit the economy or environment. For example, there is a solar tax credit available to taxpayers who purchase solar panels for their home. There is also a federal adoption tax credit that helps offset adoption costs. These credits reward behaviors that the government deems beneficial to society.  

How do tax credits reduce my tax bill? 

As mentioned, a tax credit is a dollar-for-dollar reduction of your income. Let’s say your tax liability is $1,000 but you are eligible for a $750 tax credit. This would reduce your tax liability to $250. There are two types of credits: refundable and nonrefundable. Refundable credits allow you to receive the full amount of the credit, even if it exceeds your tax liability. For example, if your tax bill is $1,000 and you claim $1,200 in refundable tax credits, you will receive a $200 refund. Nonrefundable credits do not have the same perk. If those same tax credits are nonrefundable, you would simply owe $0 and would not receive the additional $200 in your tax refund.  

What is a tax deduction? 

A tax deduction is a reduction of taxable income to lower your tax bill. You can lower your tax bill through deductions using one of two methods: claiming the standard deduction or itemizing your deductions. The standard deduction is a fixed dollar amount determined by the IRS each year that can be subtracted from your taxable income. Itemizing your deductions is more work and requires substantiation, but it allows you to deduct expenses like student loan interest, mortgage interest, retirement contributions, medical expenses, investment losses and more.  

How do tax deductions reduce my tax bill? 

Any taxpayer can claim the standard deduction. The standard deduction for single filers is $12,950 for the 2022 tax year. This means that if you are a single filer with a taxable income of $50,000, you can take the $12,950 standard deduction. Doing so would reduce your taxable income to $37,050. If you itemize deductions, you will need to tally up all your eligible expenses on Schedule A of Form 1040. This typically only makes sense to do if you have enough expenses to exceed the standard deduction. For example, if last year you had a lot of medical expenses, paid a lot of mortgage interest, or incurred disaster losses that were not insured, itemizing might be the best option for you. Finally, there is something called an above-the-line deduction, which is essentially a deduction that you can take to decrease your tax bill even further after taking the standard deduction. Some examples are self-employment tax, health insurance premiums for self-employed, and student loan interest. 

Tax Relief During Tax Season 

The bottom line is that both tax credits and deductions can help lower your tax bill. Many taxpayers may wonder which is better. Tax credits have a slight edge since they directly reduce taxes dollar-for-dollar whereas tax deductions will depend on your marginal tax bracket. For example, a single filer who earns $60,000 a year has a tax rate of 22%. If they had a $10,000 deduction, their taxable income would drop to $50,000 and would result in a tax bill of $11,000.  

$50,000 x 0.22 = $11,000 

If this same taxpayer had a $10,000 credit instead of a deduction, their calculated tax would be $13,200 before the credit and $3,200 after the credit.  

$60,000 x 0.22 = $13,200 $13,200 – $10,000 = $3,200 

Figuring out how to file your return yourself can be tricky and intimidating. Our team of qualified and dedicated tax professionals can help if you have tax debt. If you need tax help, call Optima at 800-536-0734 for a free consultation.