What’s the difference between a tax credit and a tax deduction? Both lower your total tax liability, but there is a clear difference between the two. Which one is better? Which will save you the most money? Generally speaking, a credit is more advantageous than a deduction, although somewhat more difficult to qualify for.
A tax credit reduces the actual taxes owed. In other words, the amount of the credit is deducted from the actual tax liability. So, if you owe $5,000 in tax based on your taxable income, but you are also eligible for a $1000 credit, you will only owe $4,000 in taxes for the year.
A tax deduction is an expense or an amount of money which lowers your taxable income. It’s subtracted “off-the-top” from the amount of money you made throughout the year, your gross income.
A tax deduction decreases your adjusted gross income, which in tax jargon is more commonly known as your AGI. Your AGI is used to determine your taxable income, which in turn determines your tax liability depending on your filing status. As you can see, a tax deduction is a little more far removed from the actual calculation of tax, making it less predictable than a credit. Not only that, a deduction is not a dollar for dollar reduction of tax, so the deduction does not yield as high of a tax savings as a credit.
Using the example above, if you owe $5,000 in tax as a person filing single, your taxable income is around $34,600. If we add an additional $1,000 deduction as we did with the credit in the previous example, the taxable income is now $33,600. The new tax owed on this amount for a person filing single is $4,750. So, a $1,000 deduction for a person filing single lowers the tax liability by $250. Obviously, a $1,000 credit for this person yields $750 more in tax savings than a $1,000 deduction.
Some of the tax credits available are as follows: American Opportunity and Lifetime Learning education credits (Form 8863), Child and Dependent Care credit (Form 2441), Elderly and Disabled credit (Schedule R), Retirement Savings Contribution credit (Form 888), the Child Tax Credit (Form 8901), and the Adoption credit (Form 8839). There are also many others for which you may be eligible.
Some of the tax deductions available include: Health Savings Account, Moving expenses, Alimony paid, Traditional IRA contributions, Penalty on early withdrawal of savings, various self-employed deductions, and many others.
The best strategy when figuring your tax liability is to gather all of the information you can about which credits and deductions you may be eligible for. How each impacts you depends upon your own unique tax situation.
Taxbrain’s self-guided, flexible questionnaire asks you as series of questions. Based on your answers, it determines which tax credits and deductions are available for your situation. Get your free Taxbrain account today, and get the refund you deserve.