Tax Credits and Tax Deductions: What’s the Difference?

By Mitchell J. Smilowitz, CPA

We often throw around the terms tax credits and tax deductions when discussing ways to reduce the taxes you pay. But they work very differently to reduce your tax liability. Here’s a brief explanation of each.

Tax Credits

A tax credit reduces the actual amount of tax you owe. Tax credits reduce tax liability dollar-for-dollar. If you owe $1,000 in taxes and have a $100 tax credit, your tax bill is reduced to $900.

There are three types of tax credits.

Refundable Tax Credits are most beneficial because they are paid out in full regardless of the amount of taxes you owe. If the refundable tax credit reduces your tax liability to below $0, you are entitled to a refund. For example, if your tax liability is $1,000 and you are entitled to a $1,200 refundable tax credit, you will receive a $200 refund. The Earned Income Tax Credit is a popular refundable tax credit.

Nonrefundable Tax Credits can be used to reduce your tax liability to $0. A tax credit that is larger than the total taxes you owe is not paid out. Using the same example as above, if your tax liability is $1,000 and you are entitled to a $1,200 nonrefundable tax credit, you can only use $1,000 of the credit to reduce your tax liability to zero. The remaining $200 credit is, in effect, lost. You cannot carry over the credit and use it in the future. The Child and Dependent Care Credit and Lifetime Learning Credit are examples of nonrefundable tax credits.

Partially Refundable Tax Credits permit partial refunds when the tax credit exceeds your tax liability. The amount of the refund varies based on the rules governing the specific credit you are claiming. For instance, the American Opportunity Tax Credit (AOTC) for post-secondary education students allows you to claim a refundable credit of 40% of the remaining amount of the credit up to $1,000. In other words, you cannot receive more than a $1,000 AOTC refund regardless of the size of the credit for which you are eligible.

Tax Deductions

A tax deduction lowers your tax liability by reducing your taxable income. Deductions are typically expenses that can be subtracted from your gross income to determine how much you owe in taxes.

Retirement savings are one of the best tax deductions available to you. Every dollar you contribute to your JRB retirement account, up to federal limits, is subtracted from your gross income and, therefore, reduces the taxes you pay. For example, if your gross income is $50,000 and you contribute $5,000 to your JRB retirement account, your taxable income is reduced to $45,000. In 2020, this places you in the 22% tax bracket for federal taxes. The $5,000 tax deduction will reduce your taxes by $1,100 ($5,000 x 0.22).

Tax deductions are also available for mortgage interest payments, state and local taxes and healthcare expenses. However, the larger standard deduction created a few years ago reduces the value of these tax deductions because fewer taxpayers are able to itemize.

Tax credits and deductions can reduce the taxes you owe significantly, but they work very differently. Your tax preparer can offer further guidance on what credits and deductions make sense for you.

 

December 2020