Tax deductions and tax credits are part of the arcana of the tax code. They are not the same; they impact your taxes in different ways. Deductions are good; credits are better. Deductions lower your taxable income; credits lower your tax liability. If you are in the 10% tax bracket, $10 of deductions lower your tax liability by $1. Each dollar of credit, on the other hand, lowers your tax liability by $1. That’s what is meant when we say tax credits lower your tax dollar-for-dollar.
Both deductions and credits serve to lower your tax burden, but they work in different ways. Below is a description of each, and an outline of how deductions and credits are different.
Simply stated, an income tax deduction is a reduction in taxable income. You may be familiar with tax deductions that cut your taxes in broad categories, such as:
- Medical expenses
- State and local income taxes
- Property taxes
- Mortgage interest
- Charitable contributions
- Unreimbursed employee business expense
Most people love tax deductions because they usually involve expenses you have to pay anyway, such as your mortgage and property taxes. The tax benefit seems like a great way to recover money you already had to spend. However, not everyone gets to take advantage of these deductions. You have to use Schedule A to itemize your deductions instead of taking the standard deduction. Not everyone has itemized deductions greater than their standard deduction.
The standard tax deduction – what the IRS allows to reduce your adjusted gross income, even if you don’t itemize – is $6,350 for 2017 if you’re filing as single, $9,350 if you file as head of household, and $12,700 for a married couple filing jointly. Unless your deductions exceed that amount, it will not benefit you to itemize. Usually, people without a mortgage don’t benefit from itemizing, and thus can’t take advantage of all of the available deductions. That’s where tax credits come in.
While tax deductions work by lowering taxable income, tax credits are a direct reduction of the tax due. After you figure out your adjusted gross income and subtract your deductions and exemptions, you calculate your tax due. You may have an opportunity to reduce that amount, sometimes significantly, by taking advantage of any allowable tax credits.
The major tax credits usually get plenty of press, and a little controversy too, so you’ve probably heard of some of the big ones, such as:
- Earned Income Tax Credit (EIC or EITC)
- Child Tax Credit
- Child and Dependent Care Credit
- American Opportunity Credit or Lifetime Learning Credit
- Saver’s Credit
- Green Energy tax credits
The list goes on, and your tax adviser can help you sift through them to find any that may apply to you. Relevant credits are available whether you itemize or not. Nevertheless, there are confusing rules and exceptions to all of them. The main distinction for tax credits is whether they are refundable or nonrefundable.
Refundable Tax Credits
Refundable tax credits are particularly attractive because you can benefit from them even if you have no tax liability and no withholding. There are several credits in this category, including the Earned Income Tax Credit (EITC) and the American Opportunity Credit, which is partially refundable. The EITC, which is available to low-income filers, can result in a refund of several thousand dollars. As an example, if your tax liability is $600 and your Earned Income Tax Credit is $2,600, $600 of the credit would reduce your tax liability to zero, and the $2,000 balance would be refunded to you.
Nonrefundable Tax Credits and Exceptions
Nonrefundable tax credits can also make a big difference in your tax liability. In fact, they can reduce the amount you owe all the way to zero. The drawback is that the amount of your credits can’t exceed the amount of tax you owe. In short, using them will never generate a refund for you.
Some familiar nonrefundable tax credits are:
- Child Tax Credit
- Adoption Credit
- Foreign Tax Credit
- Child and Dependent Care Credit
Exceptions Can Help
While exceptions often mean bad news, in the case of the Child Tax Credit, the exception can actually boost your refund. Although the Child Tax Credit – $1,000 per dependent child under the age of 17 – is nonrefundable, you can usually shift the nonrefundable portion of the credit over to the Additional Child Tax Credit, which is refundable.
As an example, imagine this scenario:
- Your filing status is married filing jointly, with two dependent children under age 17
- You earned $45,000, all from your jobs
- Your tax liability, before figuring allowable credits, is $1,500
- Your two children allow for a Child Tax Credit of $2,000 ($1,000 each)
- But the child credit is limited to your tax liability because it’s nonrefundable, in this case $1,500
- Normally, you’d have to forfeit the remaining $500 and would not receive a $500 refund
However, the exception to the rule allows you to slide the forfeited $500 over to the Additional Child Tax Credit, which means you just have to do some math to get yourself a nice refund. The Additional Child Tax Credit lets you claim the lesser of two amounts: the amount you might have to forfeit (in this case $500) or 15% of your earned income greater than $3,000.
That’s where the tax code gets complicated again, so take a look at the calculation: 15% of your earned income in excess of $3,000 is $6,300 ($45,000 – $3,000 = $42,000; $42,000 * 15% = $6,300). Since $500 is less than $6,300, that’s the amount you’re allowed to take. Thus, instead of forfeiting the credit, you now have an extra $500 refund.
Note: The examples above are general, and may not apply in your specific situation. Always check with your tax adviser or IRS guidelines to be sure that you qualify for any deduction or credit, as there are usually income parameters or other limits that may reduce or even eliminate your eligibility.
Despite the limitations of some types of deductions and credits, you’re not facing an either/or situation. You can take advantage of all types, and that’s good news. Of course, as you can see from the calculations, finding your way to tax relief can be complicated. Good online tax preparation software can make the job much smoother, especially when disallowances and carry-forwards kick in.
Even if you use tax software, however, you need to know what the deductions and credits are, when they apply, and when you may not be able to take them.
What tax deductions and tax credits have been the most beneficial, or the most troublesome, for you?