In this article, we’ll break down what a tax deduction is, what a tax credit is, and how to tell the difference.
Choosing one or the other can be tricky, but the professionals here at Riedel-Hogan are ready to help you make the most financially beneficial decision. Both have unique benefits and depending on your specific situation, one may be optimal over the other.
What Is a Tax Credit?
Think of a tax credit as a direct, dollar-for-dollar reduction on the income tax you owe. For example, let’s say you owe $25,000 in income tax, and you have a credit balance of $10,000. This means you would pay $15,000 in taxes.
A credit can be nonrefundable or refundable. Both types of credit can let you reduce your tax liability to zero. However, a refundable credit has an added benefit: if there is any amount leftover after reducing your tax to zero, you will receive a refund of the credit balance.
Common types of tax credits include the Earned Income Credit, American Opportunity Tax Credit, and the Savers Tax Credit.
What Is a Tax Deduction?
A tax deduction, on the other hand, lowers a person’s tax liability by reducing their taxable income. In other words, the reduction you get with tax deductions depends on your tax rate and how much income you bring in. Here are some commonly overlooked tax deductions.
So, What’s the Difference?
The major difference between tax deductions and tax credits is that credits directly reduce the amount of taxes owed, and deductions lower the income you’ll pay taxes on, which in turn reduces your taxes. Tax credits are always refundable or nonrefundable. Nonrefundable tax credits can’t increase your tax refund — only the amount you owe in taxes. Imagine you receive a $1,000 nonrefundable tax credit but you owe $500 in taxes. In this case, you don’t have to pay taxes, but you don’t get the leftover $500 as a refund.
Let’s say you have a daughter wishing to attend college. There are multiple options to get a tax credit or deduction for tuition paid.
Using the American opportunity credit, a tuition of $10,000 can reduce your total tax to $2,500. It is partially refundable, meaning even if you don’t owe tax, you can still receive a refund up to $1,000.
You can also choose the lifetime learning credit for education expenses. This credit will reduce tax up to $2,000; however, this credit is nonrefundable so if you don’t pay any taxes, you will not get a refund.
A third option is the tuition and fees deduction, which lowers your taxes by up to $4,000. If you’re in the 22% tax bracket, this would equal a reduction of $880. A deduction can only lower your taxable income and the tax rate that’s used to calculate your tax owed. This can give you a bigger refund of your withholding.
We Can Help
The best option for you depends on your overall tax situation and what you qualify for. Your income may limit your choices when it comes to certain deductions and credits making it difficult to pick the best option. The tax professionals at Riedel-Hogan CPA are happy to help you sort through the complexity and figure out whether you should claim a credit, deduction, or both, if eligible.
Schedule an appointment with us for more hands-on guidance and one of our expert tax pros will assist you. You can count on Riedel-Hogan CPA to maximize the money you get back.