Taxpayers get to take a sigh of relief from time to time as they do their returns, thanks to tax credits and deductions. The government gives these tax-lowering incentives mainly as a reward to specific groups and their attributes to the economy. It’s worth noting, then, that taxpayers seeking deductions or credits should do their homework to see if they meet the set criteria to claim them. The good thing is that both will help you lower the taxes you must pay to the government so you can save some hard-earned cash. This guide will take you through what constitutes a tax credit vs. deduction, their similarities and differences, and how to claim each of them.
An Overview of Tax Credits
A tax credit is simply a direct deduction on the amount of tax you have to pay. The value of the tax credit varies depending on the source. The IRS may give tax credits to individuals and businesses; at times, the agency may also issue certain credits as grants. Here are the three types of tax credits:
Nonrefundable tax credits specify a certain amount, and any surplus money will not be refunded. Applying a $200 tax credit to a $150 tax bill, for instance, would leave a surplus of $50 that would not be refunded back to you. Good examples include adoption credits and mortgage interest credits, and there are many others.
Refundable Credit
Refundable tax credits cover the total amount of taxes owed, and any dollars that remain unclaimed get refunded back to you. The same tax credit of $200 mentioned above, then, with a tax liability of $150 would net you a $50 refund. One illustration of a well-known refundable tax credit is the Earned Income Tax Credit.
Partially Refundable Credit
Partially refundable credits go both ways. The deductions can apply to your total tax liability or your income tax. A great example is the American Opportunity Tax Credit. As much as 40% of the remaining can be refunded after successfully applying and paying all your taxes.
Tax credits, like deductions, are codified by the government, so they can appear and disappear at the whim of lawmakers. It’s advisable to consult with a tax professional to ensure you’re getting every tax credit that’s available to you.
Tax Deductions
A tax deduction is subtracted from a taxpayer’s total amount of income subject to taxation. A taxpayer with a taxable income of $40,000 and $10,000 worth of deductions will lower their taxable income to $30,000. Tax deductions often present themselves in two ways:
Standard Deduction
This is the most common type of deduction. All you have to do is request the standard deduction on Form 1040, which the IRS set at $24,800 for tax year 2020; no qualifications are needed. The majority of the people doing their tax returns are presented with a precalculated deduction statement on their taxes.
Itemized Deduction
Itemized deductions, on the other hand, are more complex and require special attention to detail. This should not be a hurdle, though, if you want to save even more on the total amount of tax you pay the government. Itemized deductions often surpass standard deductions, as you get to list and take advantage of credits such as mortgage interest, charitable donations, and many others.
Tax deductions are IRS-sanctioned means for you to reduce your tax bill, and any savvy taxpayer will take advantage of them to the full extent of the law. It’s a good idea to consult with a professional if you need guidance on how to do that.
The Purpose of a Tax Credit vs. Deduction
Governments give out credits and deductions to encourage certain patterns of behavior that aim to grow the economy or assist in some other goal. The federal government in 2008 took this approach to incentivize U.S. taxpayers to switch from analog to digital television services, for instance, offering a $40 credit for those who made the change. Tax credits and deductions can also significantly lower the price of goods that the government wants to promote. The government sought to help consumers afford electric vehicles, for instance, so it has offered a credit that can reach as high as $7,500. It’s a way to use the tax code to nudge consumers toward the greater social good.
How to Claim Tax Credits vs. Deductions
Taxpayers claim tax deductions or credits when filing their taxes every year. You can claim the standard tax deduction on IRS Form 1040. Anyone wishing to itemize their deductions will also have to fill in Schedule A as well to list the deductions they qualify for. It is always best to compare the amount of itemized deductions and standard deductions that you would get, because either one could be higher, depending on your circumstances. It’s wise to calculate all your deductions and get the taxable income using both approaches to deductions so you can determine which is best for you. You also claim many tax credits through your annual tax return on Form 1040. Those who are filing for the earned income tax credit should be sure to file Schedule EIC, which allows you to get credit for your dependents too.
Get Expert Help to Reduce Your Tax Bill
Most taxpayers aren’t too picky about choosing a tax credit vs. deduction because they’re both there to lower your taxes. You can look at Silver Tax Group in a similar vein, since our seasoned tax pros have been getting our clients the most favorable tax outcomes for years. We have the depth of tax knowledge to help you take advantage of all available credits and deductions. Contact our team today to get a quick consultation.
