When it comes to reducing your tax bill, it’s helpful to understand the difference between tax credits and tax deductions. Both offer ways to lower your tax liability, but they work in distinctly different ways.
In this blog, we break down how they function, their respective advantages, and common examples, helping you make the most of your tax savings.
Why It Matters
Tax credits and deductions are vital tools for effective tax planning. While both reduce your tax burden, they do so differently, and their benefits can vary depending on your income and circumstances. A 2023 IRS report revealed that 87.3% of tax returns utilized the standard deduction, underscoring its importance.
At the same time, tax credits like the Child Tax Credit have helped millions of Americans save directly on their taxes. Knowing how to utilize both credits and deductions can lead to substantial savings during tax season.
How Tax Deductions Work
A tax deduction reduces your taxable income, which in turn lowers the amount of income that’s subject to tax. For example, if your gross income is $75,000 and you claim $10,000 in deductions, your taxable income becomes $65,000. The actual tax savings from a deduction can depend on your tax bracket. A deduction’s value is proportional to the tax rate you pay.
For instance:
If you are in the 22% tax bracket, a $1,000 deduction would save you $220.
If you are in the 32% bracket, that same $1,000 deduction would save you $320.
Common deductions include:
Mortgage interest: Deduct interest paid on your home mortgage.
Charitable contributions: Claim donations made to qualifying organizations.
Health Savings Account (HSA) contributions: Deduct funds deposited into an HSA, which also grow tax-free
These deductions are available to those who itemize on their tax return, which involves listing individual deductions rather than taking the standard deduction.
How Tax Credits Work
Tax credits, unlike deductions, directly reduce the amount of tax you owe, providing a dollar-for-dollar reduction. For example, if you owe $3,000 in taxes and qualify for a $1,000 credit, your tax bill decreases to $2,000.
Credits are generally more valuable than deductions because they apply directly to the tax owed rather than just reducing taxable income. They fall into two categories:
- Non-Refundable Credits help you reduce your tax liability to zero but they don’t provide a refund for any excess amount.
- Refundable credits allow you to receive a refund for any unused portion of the credit. For example, the Child Tax Credit offers refunds to eligible taxpayers whose credit exceeds their tax liability.
According to the IRS website, common credits now include:
Earned Income Tax Credit (EITC) Assists low- to moderate-income workers
The Child Tax Credit provides up to $2,000 per child under 17
Lifetime Learning Credit offers a credit for qualifying education expenses
Comparing Tax Credits and Deductions
To illustrate the difference between the two, consider the following scenario for someone in the 22% tax bracket:
Tax deductions, such as a $5,000 deduction, can reduce taxable income, saving $1,100 in taxes ($5,000 x 22%).
Tax credits, like a $5,000 credit, directly reduce taxes owed by $5,000.
Clearly, tax credits are often more financially beneficial than deductions, but income thresholds or qualifying criteria typically restrict their availability.
Key Considerations and Recent Changes
Tax laws are constantly evolving, affecting the availability and rules for deductions and credits. The Tax Cuts and Jobs Act (TCJA) of 2017 nearly doubled the standard deduction, making it more advantageous for many taxpayers to opt for the standard deduction rather than itemizing. For the 2023 tax year, the standard deduction amounts are:
Single or Married Filing Separately: $13,850
Married Filing Jointly: $27,700
Head of Household: $20,800
However, taxpayers who still itemize may benefit from deductions such as:
Medical expenses: Deduct qualified expenses exceeding 7.5% of your adjusted gross income.
State and Local Taxes (SALT): Deduct up to $10,000 in combined state and local property and income taxes.
On the other hand, refundable credits like the Earned Income Tax Credit (EITC) have expanded eligibility, benefiting millions of families. For 2023, the EITC provides up to $7,430 for families with three or more qualifying children.
Tax Planning Strategies: Maximizing Your Benefits
Effective tax planning goes beyond understanding credits and deductions—it involves structuring your finances to optimize their use. For example, contributing to a retirement account like a Traditional IRA or 401(k) can reduce taxable income while building long-term savings.
Similarly, timing your charitable contributions to maximize deductions or “bunching” medical expenses into one tax year can help you cross thresholds for itemized deductions. Tax credits, such as the American Opportunity Credit for education, can be coordinated with deductions for tuition expenses, ensuring no overlap occurs.
At David’s Family CPA, we recommend a strategic planning approach, as it’s worth taking extra care to ensure that you’ve made the most of all the credits and deductions available to you.
Discovering Your Eligibility and Planning Ahead
To maximize tax savings, consider the following:
- Combine credits and deductions. For example, claim the standard deduction while utilizing above-the-line deductions like HSA contributions or educator expenses.
- Understand eligibility. Review income thresholds and other criteria for credits such as the Child Tax Credit or education credits.
- Plan ahead. Take advantage of opportunities like retirement contributions or charitable donations before the tax year ends to maximize deductions.
Don’t hesitate to get in touch with David’s Family CPA if you’re unsure about any deductions or credits or your eligibility for them. A well-informed business owner can significantly reduce your tax liability.
However, the IRS expects to see documents! Never forget the importance of diligent tax recordkeeping, and try to avoid the ‘receipts-in-a-shoebox’ method.