Although paying taxes is a fact of life, the IRS offers taxpayers the ability to reduce what they owe via various tax deductions and tax credits. But it’s not as simple as it sounds: Before you can qualify for each deduction or credit, you must meet specific criteria. And even though both deductions and credits can lower taxes, the way that they affect your overall tax bill and potential tax refund can be very different.
Here’s what you need to know about the differences between tax deductions and tax credits and how they can help you reduce your tax bill and maximize your tax refund.
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The value of a tax credit is easy to measure because each dollar of credit reduces your tax liability by one dollar, regardless of your tax bracket. The value of a tax deduction, on the other hand, varies depending on your tax bracket because a tax deduction only reduces your taxable income.
You must multiply your marginal tax rate by the amount of the deduction to determine how much money the deduction saves you; the higher your marginal tax rate, the more valuable the deduction is to you. For example, if you can deduct $5,000 for the contributions you made to a traditional IRA and you fall in the 15 percent tax bracket, multiply $5,000 by 0.15 to find that the deduction saves you $750 on your taxes. But, if you were in the 33 percent tax bracket that tax year, that same $5,000 deduction will save you $1,650.
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What Are Tax Deductions?
Tax deductions are amounts that you use to reduce your taxable income before you calculate how much tax you owe. For example, if you make $55,000, but you qualify for a $1,000 tax deduction, your taxes will be calculated as if you only made $54,000 during the year.
Deductions include both adjustments to income and itemized deductions. You can claim adjustments to income — sometimes referred to as “above-the-line” deductions — regardless of whether you claim the standard deduction. Adjustments to income include writing off student loan interest, traditional IRA contributions, educator expenses and contributions to health savings accounts.
Itemized tax deduction examples include charitable contributions, mortgage interest, medical expenses and state and local taxes. Each year, you have to decide whether to itemize your deductions or to take the standard deduction, which varies depending on your filing status.
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What Is a Tax Credit?
A tax credit is an amount that is subtracted directly from the amount of tax that you owe. For example, if you owe $4,000 in taxes and qualify for a $1,000 tax credit, you will only owe $3,000 in taxes.
Tax credits fall into two categories: refundable credits and nonrefundable credits. Nonrefundable credits can only be used to reduce your income taxes to $0, but once your total taxes for the year get to $0, nonrefundable credits can’t increase your refund further. Refundable credits, on the other hand, can lower your total below zero so you could end up getting back more than you paid in.
For example, say your total tax for the year is $1,500. A $2,000 nonrefundable tax credit will reduce your total tax to $0, but the last $500 of the credit is wasted. But if that $2,000 tax credit is refundable, you’ll get an additional $500 tacked on to your refund.
Examples of refundable tax credits include the earned-income tax credit, the premium tax credit and the additional child tax credit. The retirement savings contribution credit and the lifetime learning credit are examples of nonrefundable credits. The American opportunity tax credit is a partially refundable tax credit, which means a portion of the credit can be used to reduce your total tax below zero.