Both tax credits and tax deductions can reduce your tax bill, but in different ways. A tax credit directly reduces the amount of tax you owe to the IRS. A tax deduction reduces your taxable income so that you are taxed on a lower amount.
What is the difference between tax credits and tax deductions?
A tax credit directly reduces the amount of tax you owe to the IRS, while a tax deduction reduces your taxable income.
A tax credit can be refundable, meaning the remaining amount is sent to you by the IRS. In contrast, a tax deduction will not result in a cash refund unless it reduces your income to the point where your taxes paid through withholding or estimated taxes exceed your tax liability.
A tax credit also allows you to claim a tax deduction. However, you must choose between the standard deduction for your tax situation or itemizing deductions because you cannot do both at the same time.
How do tax credits and tax deductions work?
A tax credit directly reduces the amount of tax you owe to the IRS. It is treated just like you made a payment to the IRS. Tax credits can be partially or fully refundable. Refundable credits can lead to a cash refund.
A tax deduction is considered less valuable than tax credits because it can only reduce the amount of income that is taxed. There is the standard deduction and there are itemized deductions.
You cannot itemize deductions if you choose the standard deduction. It’s an either/or decision. For example, if you finish preparing your tax return and owe the IRS $1,000, then realize you can claim a tax credit worth $2,000. This tax credit will cover your $1,000 tax bill, leaving you with $1,000.
If the credit you claimed is non-refundable, the IRS will keep that $1,000. You won’t benefit from the tax credit if you don’t owe any amount to the IRS because there won’t be a tax bill to cancel out. However, the government will send you the remainder of that $1,000 if the tax credit is refundable.
For tax deductions, you will only be taxed on $50,000 of your income if you earned $55,000 last year and qualify for $5,000 in tax deductions.
Types of tax credits
Some of the most popular tax credits include:
- Earned Income Credit
- American Opportunity Credit (for education expenses)
- Earned Income Tax Credit
- Child Tax Credit
- Child and Dependent Care Credit
- Credit for the Elderly or Disabled
- Lifetime Learning Credit (for education expenses)
- Credit for Other Dependents (for dependents who don’t meet the Child Tax Credit age requirements)
- Premium Tax Credit (for health insurance purchased under the Affordable Care Act)
- Saver’s Credit (for contributions made to retirement accounts)
Note: This is not a comprehensive list of all tax credits available for claims. You can find a complete list of available credits and deductions on the IRS website.
Earned Income Tax Credit
The Earned Income Tax Credit (EITC) is designed to put money into the pockets of low to moderate-income taxpayers.
The Earned Income Tax Credit is refundable, but you can only benefit from it if your income is below a certain threshold. You will not qualify if you do not earn any income at all. It requires earned income, as the name of the credit suggests.
The IRS provides a tool that you can use to find out if you qualify for the Earned Income Tax Credit.
Credit
Child Care and Medical Care
The reauthorization of child care and medical care compensates individuals who have paid expenses for the care of qualified dependents so they can work or look for work. Adult dependents must be physically or mentally incapable of caring for themselves. Child dependents must be under 13 years of age, or disabled and unable to care for themselves if they are 13 years old or older.
Typically, the dependency deduction works at a percentage
Source: https://www.thebalancemoney.com/tax-credit-vs-deduction-5120556
Leave a Reply