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While tax credits and tax deductions are a joy for all taxpayers, they do work differently. A tax credit is subtracted from the total amount of tax you owe, while a tax deduction is subtracted from your taxable income before your tax bill is determined. To better understand the difference between a tax credit and tax deduction, check out the example and sections below.
Example: Tax credit vs. tax deduction
The example below is based off of 2019 tax brackets for a single filer. These tax rates would be filed for in 2020.
|$5,000 Tax Credit||$5,000 Tax Deduction|
|Adjusted Gross Income (AGI)||$85,000||$85,000|
|Final Tax Bill||$15,400||$17,600|
In the example above, both the tax credit and tax deduction examples began at a 24% tax rate based on the AGI of $85,000. With the tax deduction, the $5,000 is subtracted from the AGI and therefore lowered the tax rate from 24% to 22%. This left the final tax bill at $17,600 ($80,000 x 22%).
With the tax credit, the tax rate remained at 24% since the credit is subtracted from the actual tax bill of $20,400. After subtracting the $5,000 credit from the bill, the final tax cost ends up being $15,400 ($20,400 – $5,000).
While this is one example of a tax credit vs. deduction, everyone’s situation can be different. Pay attention to how your tax deduction may affect your tax rate, as well as whether or not your tax credit is refundable or nonrefundable. To learn more about each option, read on below.
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 on their tax bill the year it’s used.
There are two types of tax credits to be aware of. These include:
- Nonrefundable tax credits: This means that you will receive a refund up to the amount you owe on your tax bill. For example, if your tax bill is $800 and you have a nonrefundable tax credit of $1,000, your final tax bill will be $0 and you won’t receive a $200 check for the difference.
- Refundable tax credits: This means that you get a refund for the total amount of your tax bill, plus anything past it. For example, if your tax bill is $800 and you have a refundable tax credit of $1,000, your final tax bill will be $0 and you will receive a $200 check for the difference.
Congress has the ability to change tax credits, both refundable and nonrefundable, 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. 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 2019 and 2020 tax years, the standard deductions are as follows:
|Filing Status||2019 Standard Deduction||2020 Standard Deduction|
|Married filing jointly||$24,400||$24,800|
|Married filing separately||$12,200||$12,400|
|Head of household||$18,350||$18,650|
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.
Final thoughts on tax credits vs. tax deductions
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, from education to your mortgage insurance premium.
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.
Author: Jeff Gitlen