There are several tools that individual and business taxpayers can utilize to reduce their total tax liability year to year, including tax credits and tax deductions. While credits and deductions both work to save taxpayers in the end, they work in different ways in practice. Here’s how tax credits and tax deductions function to help save taxpayers money when they file.
What is a Tax Credit?
The IRS defines a tax credit as a dollar-for-dollar reduction on a taxpayer’s income tax liability. So, a tax credit of $1,000 saves a taxpayer $1,000 in taxes in the year the tax credit is used. Tax credits are helpful to individual taxpayers, but only to a certain extent. This is because nearly all tax credits can only be used to reduce taxable income to zero, not below, based on an individual’s gross income tax liability.
The majority of tax credits offered today are non-refundable, meaning taxpayers cannot use any excess amount for future tax liabilities in years to come. Any additional amount is not refunded to the taxpayer in the year the credit is claimed.
There are, however, refundable tax credits that allow individuals to grow their tax refund by reducing one’s tax liability below zero. So, an individual who owed $1,000 in taxes but also qualified for a $2,000 refundable tax credit could receive a refund of $1,000.
Congress has the ability to change tax credits, both refundable and non-refundable, when they see fit, making it necessary to check applicable tax laws each year a tax return is filed.
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What is a Tax Deduction?
Unlike a tax credit, a tax deduction is a tool used to lower taxable income based on the percentage of a taxpayer’s marginal tax bracket. For instance, a person in the 25% tax bracket with a $1,000 tax deduction saves $250 in taxes (0.25 x $1,000 = $250). Compared to a tax credit, tax deductions for individual taxpayers are worth less on the surface because they do not reduce tax liability dollar-for-dollar.
There are two main types of tax deductions available to taxpayers: the standard deduction and itemized deductions. Consumers may only pick one type of deduction, and it is typically suggested that itemized is only used if the total deductions are higher than the standard deduction.
For the 2017 tax year, the standard deduction for single taxpayers and married couples filing separately is $6,350, while married couples filing jointly have a standard deduction of $12,700. Itemized deductions come in many forms and vary depending on income, age, and other factors, but they may be helpful to taxpayers with home mortgage interest payments, charitable donations, and state and local taxes.
Impacts on Consumers
Each year, millions of U.S. taxpayers consider the implications of taking tax credits and tax deductions, based on how much they will save on their tax bill for a single year. The reality is that both tax credits and tax deductions offer valuable savings for individual taxpayers, and the ability to claim either boils down to one’s income and overall financial situation for the year.
With that being said, because tax credits are calculated as a dollar-for-dollar reduction in the amount of taxes owed, qualifying for and claiming tax credits may be more financially helpful to taxpayers. Individuals who have significant tax deductions they qualify for in a single year may benefit more through itemizing these deductions, rather than taking the standard deduction. Overall, understanding tax credits and tax deductions is beneficial to taxpayers in all tax brackets in lessening the impact of taxes each year.