Tax Credits vs. Tax Deductions
diamondcpas
March 8, 2024

Taxpayers experience many challenges when it comes to filing their returns. It can be stressful collecting documents, understanding forms, and getting everything in on time. One common challenge is understanding the tax lingo often used when deciphering the tax code. 

At Diamond CPAs we try to work alongside to make sure terminology is clear. In this article we will be explaining the differences between tax credits and tax deductions. It is a common misconception that these terms are interchangeable, when in fact they are very different.

 

Tax Deductions: Trimming Your Taxable Income

Tax deductions are like financial pruning shears for your income tree. They allow you to trim away a portion of your income, reducing the total amount that is subject to taxation. In other words, deductions lower your taxable income, potentially moving you into a lower tax bracket.

For example, mortgage interest is a tax deduction.

Imagine you’re a homeowner with a mortgage on your primary residence. Throughout the tax year, you paid $12,000 in mortgage interest. This interest payment is eligible for deduction when you file your income tax return.

Calculation:

Let’s assume your total income for the year is $70,000, and without any deductions, you would be taxed on the full amount. However, with the mortgage interest deduction, you can reduce your taxable income.

Total Income: $70,000

Mortgage Interest Paid: $12,000

Adjusted Taxable Income:

$70,000 (Total Income) – $12,000 (Mortgage Interest Deduction) = $58,000

In this example, your taxable income is reduced to $58,000 after taking the mortgage interest deduction into account.

Tax Impact:

Assuming a simplified tax rate of 20%, your tax liability without the deduction would be:

 $70,000 * 0.20 = $14,000.

With the mortgage interest deduction:

$58,000 * 0.20 = $11,600

Tax Savings:

$14,000 (Without Deduction) – $11,600 (With Deduction) = $2,400

In this scenario, the mortgage interest deduction saves you $2,400 in taxes by lowering your taxable income.

Other common examples of tax deductions include:

  1. Medical Expenses: Certain medical expenses exceeding a certain percentage of your income may be deductible.
  2. Charitable Contributions: Donations to qualified charities can often be deducted.

Now, let’s look at tax credits to see how they differ.

 

Tax Credits: Dollar-for-Dollar Savings

Tax credits, on the other hand, are a more direct route to savings. Unlike deductions that reduce your taxable income, tax credits directly decrease the amount of taxes you owe. Think of them as a dollar-for-dollar discount on your tax bill.

For example, the child tax credit.

Imagine you are a taxpayer with a qualifying dependent child, and you are eligible for the Child Tax Credit. The Child Tax Credit provides a credit of up to $2,000 per qualifying child under the age of 17.

Calculation:

Assuming you have one qualifying child and meet the income eligibility criteria, you can claim a $2,000 Child Tax Credit.

Tax Credit:

Child Tax Credit = $2,000 per qualifying child

Tax Impact:

Assuming your tax liability before any credits is $5,000, the Child Tax Credit would directly reduce this amount.

Tax Liability Before Credit:

$5,000

Tax Liability After Credit:

$5,000 – $2,000 (Child Tax Credit) = $3,000

In this example, the Child Tax Credit reduces your tax liability by $2,000, providing a direct dollar-for-dollar saving on your taxes.

It’s important to note that the Child Tax Credit is subject to phase-out based on income. The full credit amount is available for individuals with adjusted gross income (AGI) below a certain threshold, and it gradually phases out for taxpayers with higher incomes.

As always, individual circumstances can vary, and tax laws may change.

Some common tax credits include:

  1. Energy Efficiency Credits: Installing energy-efficient improvements to your home can lead to credits.
  2. Education Credits: Credits like the American Opportunity Credit can help offset education expenses.

Unlike deductions, tax credits are often non-refundable or refundable. Non-refundable credits can reduce your tax liability to zero but won’t result in a refund if they exceed your tax liability. Refundable credits, however, can lead to a refund even if they exceed what you owe.

Choosing Wisely: Credits vs. Deductions

The key to optimizing your tax strategy lies in understanding your unique situation. In some cases, it might be more advantageous to focus on maximizing deductions, while in others, pursuing tax credits could yield greater benefits.

Consider consulting with a tax professional who can analyze your specific circumstances and guide you toward the most tax-efficient decisions. Remember, the tax landscape is ever-changing, and staying informed is crucial to making the most of available opportunities.

Whether you’re reaching for deductions or reaching for credits, both play essential roles in sculpting your tax liability. 

If you are interested in working with a tax preparer to help you assess potential tax credits and deductions, click here.

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