While perusing tax advice on the Internet, you’ll come across lists of tax deductions and tax credits that can help you reduce your tax bill. But do you know the difference between a tax deduction and a tax credit? They’re not the same. Deductions are good, but credits are better.
Both deductions and credits lower your tax bill, but they work in different ways. Deductions reduce your taxable income, while credits lower your tax liability. For example, if you’re the 25% tax bracket and you have a $100 deduction, that deduction will save you $25 in taxes (25% of $100). However, if you have a $100 tax credit, it will save you $100 in taxes. That’s what tax pros mean when they say tax credits are a dollar-for-dollar reduction in your tax liability.
Here’s a closer look at the differences between tax deductions and tax credits — and how they can help you have money on your taxes.
Simply stated, an income tax deduction reduces the amount of your income subject to your tax rate. There are two kinds of deductions:
1. Itemized Deductions
Itemized deductions are certain tax breaks you can use to lower your taxable income. Common itemized deductions include:
- Medical expenses
- State and local income taxes
- Property taxes
- Mortgage interest
- Charitable contributions
Homeowners and people who live in high-tax states love itemized deductions because they usually involve expenses they pay anyway, such as mortgage interest, property taxes, and state income taxes. The tax breaks are a great way to recover some of the money they’re already spending. However, not everyone benefits from taking advantage of these deductions.
To get a benefit from claiming itemized deductions, you have to use Schedule A to list your deductions individually instead of taking the standard deduction. The standard deduction is a fixed dollar amount that varies according to your filing status. For 2018 returns, the standard deduction is:
- $12,000 for single or married filing separately
- $24,000 for married filing jointly or qualifying widow(er)
- $18,000 for head of household
For taxpayers who are 65 or older or blind, the standard deduction increases by $1,550 for single filers and $1,250 for married taxpayers.
You can claim the standard deduction or itemized deductions, whichever gives you a bigger tax benefit. Many taxpayers don’t have itemized deductions greater than their standard deduction, but that doesn’t mean they can’t take advantage of tax deductions at all.
2. Above-the-Line Deductions
There are a handful of tax deductions that people claiming the standard deduction can still use to lower their tax bills. These are referred to as “above-the-line” deductions because they reduce your adjusted gross income (AGI), whereas itemized deductions reduce your taxable income.
AGI is a measure of your gross income for the tax year, minus certain deductions. AGI is an important number for many people because it influences a taxpayer’s eligibility to claim many other deductions and credits. For example, when you claim medical expenses as an itemized deduction, you only benefit if your medical expenses exceed 7.5% of your AGI for your 2018 taxes. So a taxpayer with an AGI of $40,000 and medical expenses of $4,000 could claim $1,000 as a deduction, or $4,000 in expenses minus the 7.5% limit (7.5% x $40,000 = $3,000).
On the other hand, a taxpayer with an AGI of $60,000 and $4,000 of medical expenses wouldn’t get any benefit from those medical expenses; they would need to have more than $4,500 ($60,000 x 7.5%) to get a deduction. That’s why above-the-line deductions are so valuable — they impact your ability to claim many tax breaks.
Above-the-line deductions appear in the “Adjustments to Income” section of Schedule 1 attached to Form 1040. They include:
- Educator expenses
- Certain business expenses of reservists, performing artists, and fee-based government officials
- Health savings account (HSA) contributions
- Moving expenses for members of the armed forces
- The deductible portion of self-employment taxes
- Contributions to self-employed SEP IRA, SIMPLE IRA, and other qualified plans
- Self-employed health insurance premiums
- Penalties on early savings withdrawals
- Alimony paid
- Deductible contributions to IRAs
- Student loan interest
Above-the-line deductions may not be as valuable as tax credits, but you can still benefit from them. By lowering your AGI, these deductions may enable you to claim other tax breaks based on income limits.
While tax deductions lower your taxable income, tax credits are a direct reduction of your tax due. After you figure out your AGI, apply either the standard deduction or itemized deductions, and calculate your tax due, you may be able to reduce that amount — sometimes significantly — by taking advantage of available tax credits.
The major tax credits usually get plenty of press, so you’ve probably heard of some of them:
- Earned Income Tax Credit (EITC). The Earned Income Tax Credit is designed for families with low or moderate incomes. For the 2018 tax year, it’s worth between $519 and $6,431, depending on how many children you have, your marital status, and how much you make.
- Child Tax Credit. The Child Tax Credit is worth up to $2,000 per child and up to $500 per non-child dependent. This credit is phased out for higher-income taxpayers.
- Child and Dependent Care Credit. The Child and Dependent Care Credit is designed to offset the cost of care for children or other dependents so that you can work. It’s worth between 20% and 30% of up to $3,000 of costs for one child and $6,000 of costs for two or more children.
- American Opportunity Tax Credit. The American Opportunity Tax Credit is worth up to $2,500 per student. This credit is for tuition, activity fees, books, supplies, and equipment during the first few years of undergraduate education. The student must be enrolled at least half-time to qualify for the credit.
- Lifetime Learning Credit. The Lifetime Learning Credit is worth up to $2,000 per return for qualified tuition and related expenses. It can be used for undergraduate, graduate, and professional degree courses.
- Adoption Credit. This credit coves up to $13,840 in adoption costs per child. If the credit exceeds the amount of tax owed, you can carry the unused portion of the credit forward for up to five years.
- Saver’s Credit. The Saver’s Credit is designed to help low- to moderate-income taxpayers save for retirement in an IRA or employer-sponsored retirement plan. It’s worth up to $2,000 for single taxpayers or $4,000 for married couples.
- Residential Energy Tax Credit. The Residential Energy Tax Credit is worth up to 30% of the cost of alternative energy systems installed on or in your home, including a solar water heater, solar electric equipment, wind turbines, and fuel cell property.
- Plug-In Electric-Drive Motor Vehicle Credit. This credit is worth up to $7,500 for buying a plug-in electric vehicle. The car must have at least four wheels and a rechargeable battery with a capacity of at least 4 kilowatt hours. To qualify, you must buy the car new; used cars aren’t eligible.
- Foreign Tax Credit. This credit is available for taxpayers who work in a foreign country or have investment income from a foreign source. It provides a credit for foreign taxes paid or owed to a foreign country or on a U.S. possession if you’re subject to U.S. tax on the same income.
Some credits are refundable, and others are non-refundable.
Refundable Tax Credits
Refundable tax credits are particularly valuable because you can benefit from them even if you have no tax liability and haven’t had any tax withheld. There are several credits in this category, including the EITC, the American Opportunity Tax Credit, and a portion of the Child Tax Credit.
For example, say your tax liability is $1,000, and your calculated EITC is $2,500. One thousand dollars of the EITC would reduce your tax liability to zero, and you would be refunded the $1,500 balance.
Non-Refundable Tax Credits
Non-refundable tax credits can also make a big difference in your tax liability. However, while they can reduce the amount you owe to zero, the credit cannot exceed the amount of tax you owe. In other words, non-refundable credits will never generate a refund over and above the amount you paid in via withholding or estimated payments for the year.
Non-refundable credits include:
- Child and Dependent Care Credit
- Lifetime Learning Credit
- Adoption Credit
- Saver’s Credit
- Residential Energy Tax Credit
- Plug-In Electric-Drive Motor Vehicle Credit
- Foreign Tax Credit
Many credits have complex rules, income limits, and exceptions. Your tax adviser can help you sift through the available credits and find any that apply to you.
Navigating the limitations, rules, and exceptions that apply to these tax deductions and tax credits can be challenging. Using online tax preparation software can make the job much easier.
Whether you prepare your return yourself or hire a tax pro, take some time to look into which of these tax breaks apply to your situation. Taking advantage of one or more of them can make a big impact on the amount of tax you owe or the refund you’ll get.
Which tax deductions and credits have been the most beneficial to you?